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ed Unit tes .. . Sta S. HRG. 103-137 PROBLEMS IN COMMUNITY DEVELOPMENT BANKING, MORTGAGE LENDING DISCRIMINATION, REVERSE REDLINING , AND HOME EQUITY LENDING HEARINGS BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED THIRD CONGRESS FIRST SESSION ON FEBRUARY 3, 1993-COMMUNITY DEVELOPMENT BANKING FEBRUARY 17, 1993-REVERSE REDLINING; PROBLEMS IN HOME EQUITY LENDING FEBRUARY 24, 1993-MORTGAGE AND OTHER LENDING DISCRIMINATION Printed for the use of the Committee on Banking, Housing, and Urban Affairs 70-832 CC U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1993 For sale bythe U.S. Government Printing Office Superintendent of Documents, Congressional Sales Office , Washington, DC 20402 ISBN 0-16-041270-6 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS DONALD W. RIEGLE, JR., Michigan, Chairman PAUL S. SARBANES, Maryland ALFONSE M. D'AMATO, New York PHIL GRAMM, Texas CHRISTOPHER J. DODD, Connecticut JIM SASSER, Tennessee CHRISTOPHER S. BOND, Missouri RICHARD C. SHELBY, Alabama CONNIE MACK, Florida JOHN F. KERRY, Massachusetts LAUCH FAIRCLOTH , North Carolina RICHARD H. BRYAN, Nevada ROBERT F. BENNETT, Utah BARBARA BOXER, California WILLIAM V. ROTH, JR. , Delaware PETE V. DOMENICI , New Mexico BEN NIGHTHORSE CAMPBELL, Colorado CAROL MOSELEY-BRAUN, Illinois PATTY MURRAY, Washington STEVEN B. HARRIS, Staff Director and Chief Counsel HOWARD A. MENELL, Republican Staff Director KONRAD S. ALT, Counsel KEVIN G. CHAVERS, Counsel JEANNINE S. JACOKES, Professional Staff Member MARK KAUFMAN, Legislative Fellow AMY L. KOSTANECKI, Professional Staff Member MATTHEW D. ROBERTS, Counsel MICHAEL A. ROTGIN, Professional Staff Member RAYMOND NATTER, Republican General Counsel IRA PAULL, Republican Senior Counsel EDWARD M. MALAN, Editor (II) 93-242788 F K 6 2 34567252285 CONTENTS WEDNESDAY, FEBRUARY 3, 1993 Opening statement of Chairman Riegle Opening statements, remarks, or prepared statements of: Senator Mack Senator D'Amato Senator Shelby Senator Bryan Prepared statement Senator Moseley- Braun Prepared statement Senator Boxer Senator Bennett Senator Domenici Senator Mitchell Page 1 61 20 61 20 30 61 WITNESSES (III) 6 62 62 64 193 8 81 203 11 86 210 12 88 88 90 91 214 22 Milton O. Davis, chairman, South Shore Bank of Chicago Prepared statement I. Renewing community economics II. Shorebank Corporation Response to written questions of Senator Riegle Lyndon Comstock, chairman, Community Capital Bank Prepared statement Response to written questions of Senator Riegle Steven Lopez, president and CEO, Southside Bank, Grand Rapids , MI Prepared statement Response to written questions of Senator Riegle Edward H. McNamara, Wayne County executive, Detroit, MI Prepared statement I. Why Wayne County has chosen a Development Bank II. Why a Development Bank complements conventional lending III. The role of Government Response to written questions of Senator Riegle Pauline Nunez-Morales, executive director, New Mexico Community Development Loan Fund, Albuquerque, NM; accompanied by Jeremy Nowak, executive director, Delaware Valley Community Reinvestment Fund Prepared statement The work of the New Mexico community development loan fund The Loan Fund industry Strategic Federal support Funding Human capital development Corresponding Federal policy changes Ronald L. Phillips, president, Coastal Enterprises, Inc., Wiscasset, ME Prepared statement Introduction ...... Purpose oftestimony The legacy of community development corporations CEI profile .... Examples of CEI projects Filling the credit gap ..... Example of gap financing Recommendations 42 92 92 93 95 95 96 97 45 97 97 97 97 98 98 99 99 99 IV Page Ronald L. Phillips, president, Coastal Enterprises, Inc., Wiscasset, ME─Continued Prepared statement-Continued Conclusion Response to written questions of Senator Riegle Robert Jackson, treasurer, Quitman County Federal Credit Union, Marks, MS Prepared statement Community development credit unions The story of Quitman County Position paper Amendments Response to written questions of Senator Riegle Michael Swack, co-director, Institute for Cooperative Community Development, Manchester, NH ................. Prepared statement Additional testimony Response to written questions of Senator Riegle Jeremy Nowack 99 222 48 109 109 109 111 112 229 51 113 115 234 59 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Principles of Community Development Lending and Proposals for Key Federal Support ACORN, comments by Deepak Bhargava, director National Association of Home Builders Woodstock Institute Neighborhood Housing Services of New York City, Inc. Consumer Federation of America First Nations Development Institute: The Oweesta Program 119 131 136 146 170 177 186 WEDNESDAY, FEBRUARY 17, 1993 Opening statement of Chairman Riegle Opening statements, comments, or prepared statements of: Senator D'Amato Senator Campbell Prepared statement ……………………........................ Senator Bennett Senator Kerry Senator Domenici Prepared statement Senator Shelby Senator Boxer Senator Moseley-Braun Prepared statement Senator Sarbanes 243 246 248 305 248 249 250 305 251 252 270 306 284 WITNESSES Scott Harshbarger, Attorney General, Commonwealth of Massachusetts Prepared statement I. Introduction II. Background-Setting for the problem III. Allegations-Apparent scope of problem IV. Actions by the task force V. Conclusions and recommendations Kathleen Keest, National Consumer Law Center, Boston, MA Prepared statement The causes The victims The perpetrators Allocating responsibility Recommendations 253 307 308 308 309 309 312 256 313 314 315 315 316 318 V Page Kathleen Keest, National Consumer Law Center, Boston , MA-Continued Prepared statement-Continued Regulatory reform for predatory home equity lending Alternatives for home equity loans regulatory approaches Terry Drent, Ann Arbor Community Development Department, Ann Arbor, MÍ Prepared statement ……………………............................... Problem Background Recommendations Summary John Hamill, president, Fleet Bank of Massachusetts Prepared statement 1. Introduction of Fleet Financial Group and Fleet Finance 2. A general overview of the consumer finance industry 3. The role of home equity loans in consumer finance transactions 4. Why costs to borrowers for home equity loans are higher than costs for conventional mortgage loans 5. Fleet Finance's development of business 6. The Georgia lawsuits 7. Recommendations of Fleet Finance Eva Davis, resident, San Francisco, CA Prepared statement Annie Diggs, resident, Augusta, GA Prepared statement John Long, attorney, Dye, Tucker, Everitt, Wheale & Long Prepared statement I. High finance charges II. Redlining and reverse redlining III. Issues IV. Recommendations V. Conclusion Bruce Marks, executive, Union Neighborhood Assistance Corporation (UNAC), Boston, MA Prepared statement 320 323 258 329 329 329 331 331 261 332 332 333 333 334 335 336 340 291 382 292 382 294 392 393 395 397 397 398 297 433 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Fleet Financial Group, Inc. South Mississippi Legal Services Corp. St. Ambrose Legal Services Southern Arizona Legal Aid, Inc. State of New York, Department of Law Legal Aid Foundation of Los Angeles City of New York, Department of Consumer Affairs Dye, Tucker, Everitt, Wheale & Long 436 446 447 448 451 457 460 469 WEDNESDAY, FEBRUARY 24, 1993 Opening statement of Chairman Riegle Opening statement, comments, or prepared statement of: Senator D'Amato Senator Faircloth Senator Moseley- Braun Prepared statement Senator Campbell Prepared statement Senator Sarbanes ..... 473 475 476 482 523 483 523 483 WITNESSES Richard Syron, President, Federal Reserve Bank of Boston, Boston , MA Prepared statement Response to written questions of Senator Riegle 478 524 581 VI Page John P. LaWare, Chairman, Federal Financial Institutions Council (FFIEC), Washington, DC Prepared statement Recent developments FFIEC efforts Federal Reserve efforts Compliance examinations Consumer complaint program Community affairs program Conclusion Response to written questions of Senator Riegle Address to the Bank Administration Institute's 1993 Bank Audit, Compliance and Security Conference James Turner, Acting Assistant Attorney General for Civil Rights, Department of Justice, Washington, DC Prepared statement I. The mortgage lending discrimination lawsuit II. Enforcement activities after Decatur Response to written questions of Senator Riegle Retha Wilson, board member, Michigan ACORN, Detroit, MI Prepared statement Summary of testimony Summary of recommendations Testimony of Willard Brown Joint statement of: ACORN, Center for Community Change, Center for the Study of Responsive Law, Consumer Union, First Nations Development Institute, League of Cities, NAACP, National Council of La Raza, National Neighborhood Coalition , Public Citizen's Congress Watch Response to written questions of Senator Riegle John Gamboa, executive director, Latino Issues Forum, San Francisco , CA Prepared statement Allen Fishbein, general counsel, Center for Community Change, Washington, DC Prepared statement Appendix I-A cronology of fair lending enforcement Appendix II -Wall Street Journal article, February 19, 1993 , entitled " Home Equity" Gale Cincotta, executive director, National Training and Information Center, Chicago, IL Prepared statement Discrimination and disinvestment Problems with CRA enforcement Fair lending violations are not translating into CRA ratings What Congress can do 485 526 526 527 529 529 530 531 531 589 827 488 532 533 536 597 506 538 538 539 550 551 582 509 554 511 561 571 574 515 575 575 575 576 576 ADDITIONAL MATERIAL Supplied for THE RECORD 646 First Nations Development Institute Response to written questions of Senator Riegle from : 650-824 Federal Reserve System 671 Federal Deposit Insurance Corporation 692-816 Office of Thrift Supervision 730-821 Comptroller of the Currency Federal Reserve Bank of Boston, paper entitled "Mortgage Lending in Boston : Interpreting HMDA Data" by Alicia H. Munnell, Lynn E. Browne, James 762 McEneavey, Geoffrey M.B. Tootell COMMUNITY DEVELOPMENT BANKING WEDNESDAY, FEBRUARY 3, 1993 U.S. SENATE , COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS , Washington, DC. The committee met at 10:40 a.m., in room 562 of the Dirksen Senate Office Building, Senator Donald W. Riegle, Jr. (chairman of the committee) presiding. OPENING STATEMENT OF CHAIRMAN DONALD W. RIEGLE, JR. The CHAIRMAN. The committee will come to order. Let me welcome this overflow gathering this morning. We are in a different committee room because the normal committee room is undergoing a regular refurbishing and it is done every few years, and we will be back in that room shortly. I want to also indicate the reason we are starting later than our announced time, which is that after scheduling this hearing for 10 o'clock, some votes were scheduled on the Senate floor which we have just completed . And so that necessitated members being there and delayed the opening of this hearing. I say to our witnesses particularly, I appreciate their patience today. Before we begin this morning's hearing directly, I want to announce for the record that, as members arrive, they will be recording their votes on favorably reporting the nomination of Laura Tyson to be Chairperson of the Council of Economic Advisers. We will begin the period for voting now and it will extend until this hearing concludes. If a quorum is established in that time, which I anticipate , the final vote will be announced as we adjourn and the nomination will be reported to the full Senate later today. Let me now move to the subject that brings us here this morning. This is a very important hearing, I think one of the most important that is likely to happen this year with respect to the new direction that the country needs to take and is preparing to take with respect to revitalizing our urban communities particularly. We are here today to talk about community development banking. President Clinton , to his credit, has advocated the creation of a national network of community oriented financial institutions dedicated to the revitalization of distressed urban neighborhoods , and as well, depressed rural economies . Our distressed communities are in need, and really urgent need, of new strategies to address neighborhood disintegration and clearly inadequate access to capital . (1) 2 That need was clearly demonstrated by the riots in Los Angeles and it is obvious from the general condition of many of our communities where homelessness, unemployment, and crime are really at crisis levels . Recent studies, official, national studies show that redlining and discrimination are significant problems , and that many people are denied credit based on the color of their skin rather than on any measure of their true creditworthiness . We are going to be examining this issue of mortgage discrimination at a hearing on February 24. But the point today is that more than ever, we need new initiatives for revitalization , particularly in our communities that are in the greatest difficulty today. I believe that any new Federal community lending initiative should be built upon the roles played by all existing lending institutions. Enforcement of the Community Reinvestment Act, I think must be improved and strengthened so that traditional lenders increase the flow of credit to low-income and minority communities. However, the Federal Government should also , as recommended by President Clinton , experiment with new and additional models that can further increase availability of capital and build the capacity of residents to revitalize their own neighborhoods . Any new initiative must recognize that both efforts are necessary, both through the established channels and through new channels , and at the same time ensure that the safety and soundness of federally insured depository institutions are not put in jeopardy. Our witnesses today will focus on some of the new models for promoting revitalization , including community development banks , and other types of community lending institutions. Community development banks are organizations the primary mission of which is to revitalize their communities by investing in them. They combine the structure and expertise of an insured depository institution with the commitment typical of a community based, nonprofit organization. Currently, there are four such institutions in the Nation . Two of these institutions, South Shore Bank and Community Capital Bank are here with us today and incidentally are located in the home States of members of this committee, Ranking Member D'Amato, who will be here in due course , and Illinois Senator Carol MoseleyBraun. We will also hear from two prospective community development banks who will discuss some of the pitfalls encountered in starting new institutions of this kind. We will also hear from representatives of several nonprofit lenders , including a group from Senator Domenici's home State of New Mexico . These community - based lenders include a wide range of organizations that promote revitalization and will help us get a fuller understanding of the field of community banking as it is happening across the country. I want to welcome all of our witnesses this morning, and I want to extend a special thanks to Steven Lopez, here from my home State of Michigan , and also the County Executive of Wayne, Edward McNamara. I want to say a word more about that in a minute. 3 Finally, let me say that I also look forward to hearing from the administration as soon as they are ready to testify on this important issue, and put their package and recommendation before the Congress. During the campaign, President Clinton said that he would like to create , A national network of community development banks to provide small loans to low-income entrepreneurs and homeowners in the inner cities. These banks will also provide advice and assistance to entrepreneurs, invest in affordable housing, and help mobilize private lenders. So I know from that statement and things said since, that this is a very high priority for the new administration , and the committee will move forward very promptly as soon as they have put their proposal on the table for us. Let me now just finally say a word before calling on our other members , and then going to our first panel of witnesses . It is a particular pleasure for me to welcome my two Michigan representatives who are here at the table today. But I want to say a special word about Ed McNamara , because it is very difficult to make local government work sometimes and there are a lot of problems , especially because of changes in funding patterns and the starvation , I think, of financial help from the National Government to help local communities deal with some of their problems. I think Ed McNamara is probably without question the most ef fective county executive anywhere in the country. I am very proud of that personally, and my State is very proud of that as a matter of his work and his accomplishments . I have found, over the years , that if you want somebody that can turn a problem into a solution , a good person to call is Ed McNamara. So I am very pleased that he is here today and I am very much interested in what he will be saying in his comments and the concept that he has in mind in our State, as does Mr. Steven Lopez as well , representing from the perspective of folks in the Grand Rapids area. So before going to our witnesses, I know Senator D'Amato will be arriving shortly, let me now yield for any brief opening comments that members might have . Senator Mack. OPENING COMMENTS OF SENATOR CONNIE MACK Senator MACK. Thank you , Mr. Chairman. My comments will be brief. Unfortunately, I am going to have to leave in about 20 or 25 minutes, and I really wanted to have the opportunity this morning to have the input from the two panels. Let me say, at the outset, that the issue that we are going to be talking about this morning I think is a significant one. It is dif ficult for me to believe that capitalism can work without capital. There are areas of our country in which we know that capital is now flowing. Credit is to the economy what oxygen is to the body. And without capital, without credit, it is very hard to see how you can bring to fruition all the other efforts of empowerment that is a popular word that is been used for a number of years now. 4 I must say to you, however, having spent 16 years in the banking business myself, having had to go through the process of making decisions about who to lend to and who not to lend to, the difficulties in putting together new organizations with new missions is a very very challenging one. While I come here with a very open mind, and want to be supportive, at the same time, I have got some skepticism to deal with. I look forward to your testimony to kind of help me through that, if you will . So I welcome you along with the other members of the committee, and look forward to your testimony. And thank you , Mr. Chairman , for the opportunity. The CHAIRMAN. Thank you , Senator Mack. Senator Boxer. Senator BOXER. Mr. Chairman , I do not have an opening statement. I just want to commend you for holding this hearing and I look forward to hearing from the witnesses. The CHAIRMAN. Very good. Senator Faircloth, did you have an opening comment that you wanted to make? Senator FAIRCLOTH . No thank you. The CHAIRMAN. Senator Campbell . Senator CAMPBELL. No opening statement, Mr. Chairman. The CHAIRMAN . Senator D'Amato I know has a strong interest in this area, and has talked and very active with respect to the issues of the community and urban redevelopment particularly. Senator D'Amato. OPENING STATEMENT OF SENATOR ALFONSE M. D'AMATO Senator D'AMATO. Thank you very much, Mr. Chairman . Mr. Chairman , I join you in welcoming today's distinguished witnesses as the committee considers ways to promote community development in inner cities, rural areas, and other economically distressed neighborhoods of the country. I want to extend a special welcome to Lyndon Comstock, who is the chairman of Community Capital Bank in Brooklyn , and to thank him for his willingness to provide us with his insights and suggestions concerning this important issue. Our Nation's inner cities, rural areas, and other economically distressed neighborhoods are in dire need of credit for community development. We need to find a way to encourage banks and other lenders to return to these areas and to provide the credit needed for economic redevelopment . There are all sorts of community development bank proposals floating around in Washington . Some proposals require huge amounts of taxpayers' money. Other proposals call for creating a new kind of specialized community development banks. Still other proposals seek to coerce banks to make community development loans by stronger enforcement of the Community Reinvestment Act. While I know that these proposals are well intended, I do not believe that we need new kinds of banks or new Government spending programs. Instead, we should take the money and time wasted on creating paperwork to satisfy Community Reinvestment Act regulations and channel those resources into making real loans to 5 home buyers and small businesses in poorer communities all over America. Community development banks are basically ordinary banks with an extraordinary purpose. By pooling resources and talent under one roof, community development banks can focus their efforts on designing products and services that meet the special credit needs of the inner cities and rural areas. We should encourage banks, especially smaller banks, to pool their resources and carry out their community reinvestment responsibilities through investments in community development banks. If every bank invested up to 5 percent of their capital, and that happens to be the current legal limit, in a community development bank, it would dedicate almost $ 12.9 billion to revitalize our inner cities and poorer neighborhoods. This translates into $ 193 billion in new credit for community redevelopment. Now that is real money, even by Washington standards. Mr. Chairman, there are those who say this idea would enable banks to buy their way out of CRA. But I say, this is the best way for banks to buy into CRA. Instead of building mountains of paperwork in the name of CRA, banks can be building affordable housing and stores for small businesses. Under CRA, banks should get credit for giving credit. I hope to examine my proposals with today's witnesses and to work with them and other financial institutions and community groups to find the most efficient and least costly way to promote community development activities. Thank you, Mr. Chairman. The CHAIRMAN. Senator Shelby. OPENING STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Thank you, Mr. Chairman . Mr. Chairman , I ask unanimous consent that my full prepared statement be made part of the record. The CHAIRMAN. Without objection , it is so ordered. Senator SHELBY. Mr. Chairman, I am very happy to have the opportunity today to learn more about the community development banks. Since President Clinton has mentioned his interest in creating a network of community development banks, I have followed with interest the media coverage of existing community development financial institutions. There currently exist, according to my information, somewhere between 2,000 and 3,000 community development organizations. These organizations take several different structures and have a number of different missions, but seem to concentrate their efforts on developing affordable housing, creating and retaining jobs, providing credit to small businesses and micro enterprises, and providing banking services to under served members of the community. If these numbers are to be believed, these community development organizations have been extremely successful. They have created thousands of jobs, developed thousands of units of housing, and moved a significant number of Americans off public assistance through employment and self- employment opportunities. 6 I believe that community development financial institutions clearly have an important role in our financial system. They satisfy a need not met by other sectors of the financial services industry, constrained as they are by the demands of the shareholders. I look forward, Mr. Chairman, to hearing from this mornings witnesses and to see what else we can learn about the community development banks. The CHAIRMAN. Thank you, Senator Shelby. Senator Bryan . OPENING STATEMENT OF SENATOR RICHARD H. BRYAN Senator BRYAN. Mr. Chairman , thank you very much. I too would like to ask unanimous consent to have my statement made a part of the record. The CHAIRMAN. Without objection, so ordered. Senator BRYAN. I would also like to indicate to the distinguished panel that I look forward to learning more about your experience. hope it will enlighten us to some opportunities to provide additional capital to the urban centers of our communities, that are so desperately in need of additional resources to develop themselves. Thank you very much. The CHAIRMAN. Thank you, Senator Bryan. I am going to introduce each of our witnesses now, and then we will go right down the table to hear from them. First we will hear from Mr. Milton Davis who represents the South Shore Bank in Chicago, IL, often pointed to as the leading example of a community development bank. Mr. Lyndon Comstock, with Community Capital Bank of Brooklyn, NY, another very important illustration of the efforts now underway . Then Mr. Steven representing the Southside Bank in Grand Rapids, MI and Mr. Ed McNamara who is the county executive for Wayne County, coming from Detroit, as it were. I will introduce the second panel when we call them forward. Mr. Davis, we are very pleased to have you and interested to hear about your experiences and the advice you have for us. Let me say to all the witnesses, we will make your full statements a part of the record, so I want you to feel free to summarize and go right to the points you really want to stress for us. STATEMENT OF MILTON O. DAVIS, CHAIRMAN, SOUTH SHORE BANK OF CHICAGO Mr. DAVIS. Honorable Chairman and members of the committee , thank you for inviting me to appear today. It is a great honor, particularly because this committee has been at the forefront in recognizing the potential of community development banks at the same time the committee has already been able to shed considerable light on the complex issues facing distressed communities, and the range of distinct institutions and products appropriate the different market challenges in these communities . As requested, I would like to briefly provide background on Shore Bank and Southern Development Corp. , before touching on some of the distinguishing characteristics of development banks , their relationship to other banking and nonbanking activities , and the opportunities for replication. 7 Three colleagues and I formed Shore Bank in 1973. We believe that the multifaceted problems of distressed communities required large scale permanent institutions. Such institutions would have to take a business like comprehensive approach to community development. They would need high levels of credibility, expertise and market knowledge to profitably invest in the area, and to restore the confidence of private investors revitalizing healthy market forces. A bank holding company with nonbanking community development subsidiaries can have all of these characteristics . We thus conceived of a development bank as a specialized structure with the capacity to transform the market dynamics of a geographic target area. Shore Bank owns a bank, the South Shore Bank of Chicago, but it also owns a real estate development company, a minority small business investment company, and has a nonprofit community affiliate engaged in small business assistance, labor force development , and various community services all active in this targeted community in Chicago. These companies, through their coordinated activities in carefully targeted areas, aspired to comprehensive community development. While provision of credit is an important tool toward this end, it is not enough. Community development requires more than credit, and delivering credit successfully in disinvested communities requires more than a bank. In 1973, the South Shore community had rapidly changed from all white to overwhelmingly black, and no credit was being extended there. Since that time, Shore Bank has made development investments totalling $351 million in South Shore, and a few other recently targeted neighborhoods. And has financed or leveraged the renovation of nearly 8,000 housing units in South Shore alone, nearly a third of all such units in that community. While doing so, our financial performance has been comparable to peer institutions . For the last 10 years, Shore Bank's compounded annual growth rate has been 16.6 percent. Southern Development Bank Corp. , our sibling in Arkansas, was formed with Shore Bank assistance in 1988. It applies the same principles of comprehensive, coordinated interventions tailored to particular communities, to a rural area whose primary market needs are business development. Southern also owns a bank and a real estate development company, but it is nonprofit affiliate includes, in addition to a venture capital fund, a microenterprise fund and a sophisticated manufacturing, finance and consulting company. To date, Southern has invested $ 19 million and has been very profitable. In essence, these institutions work because they bring a singular focus and specialized expertise to a carefully targeted area combined with mutually reinforcing interventions . This allows the development bank to successfully manage what would otherwise be high risk investments, to more aggressively initiate, identify and evaluate development opportunities, and to address multiple dimensions of community renewal. From the point of view of banking, a development bank occupies a special niche, primarily growing the market by fostering and sup- 8 porting deals which would not be present or bankable without the comprehensive target characteristics of a development bank. For these reasons, development banks do not primarily compete with conventional banks. Instead, they are natural partners addressing complementary equally important credit needs. Unleashing the enormous credit potential of conventional banks, with appropriate incentives , is vital to strengthening the Nation's economy and to under invested communities. But if the goal is development of distressed communities , this credit is not enough. It will not reach the deals in these communities which cannot be identified or prudently banked with credit mechanisms alone . Perhaps the broader point is that different markets require different types of development products which are most effectively delivered by different types of institutions. Bank community lending departments in large banks , community loan funds, credit unions, community development corporations and others, all provide much needed but distinct products. Appropriate support should be crafted for each with the recognition that they have different needs and serve differing goals . This considerable range of activity, interest and expertise in community development relates to one final point, replication . Many talented people and capable institutions, ranging from conventional banks to loan funds to community development corporations are exploring becoming development banks . We believe that with appropriate start-up support, our experience can be widely replicated. Development banks represent an unusual model of private institution serving public purposes, offering a new partnership between the private sector and government, and effectively delivering resources to revitalize disinvested communities. As in so many areas of public need, after many years of experimentation, we know something that works. The difficult challenge is to carefully design a program which translates this knowledge into public policy. Thank you for your interest and commitment. I would of course be glad to answer questions. The CHAIRMAN. Thank you very much, Mr. Davis. Mr. Comstock, we would like to hear from you now, please. STATEMENT OF LYNDON COMSTOCK, CHAIRMAN, COMMUNITY CAPITAL BANK Mr. COMSTOCK. Thank you for inviting me to address the committee on the topic of community development banking. It is a privilege to speak after Milton Davis from Shore Bank, which has been a principal inspiration for our bank. My name is Lyndon Comstock. I am the chairman and founder of Community Capital Bank of New York City. Community Capital Bank is, as far as I know, the only commercial bank ever organized specifically as a community development bank in the United States. Our bank is now 2 years old, and has $20 million in assets . I am also the chairman of LEAP, Inc. LEAP is a nonprofit venture development organization with its office at Community Capital Bank. LEAP provides intensive management assistance, including help in sourcing risk capital, to small businesses in low -income areas of New York City. 9 At the outset, I would like to note that community development banks are only one of the categories of community development financial institutions or CDFI's, for short. I include , as CDFI's, along with community development banks, community development credit unions, community development loan funds, microenterprise funds, and venture development organizations. Each of these various categories, including rural reservation based and urban CDFI's, is performing an important service to community economic development, and could benefit from Federal support. Assisting in the expansion of existing institutions , and not just the creation of new CDFI's, is particularly important. Our bank is a member of a recently formed ad hoc coalition of community development financial institutions which advocates Federal support for building the capacity of the CDFI industry. I understand that you have been provided with a copy of the coalition's position paper, "Principles of Community Development Lending and Proposals for Key Federal Support. " I hope that is correct. The CHAIRMAN. Yes, we have that, and we are making that a part of the record. Mr. COMSTOCK. Thank you. I hope that your investigation of community development financial institutions will lead you to the same conclusion I reached some years ago. CDFI's are a highly effective, private sector means for channeling capital into community development. An investment in low- and moderate-income communities is essential to the establishment of functioning economies in those areas . To expand the capacity and therefore the impact of the CDFI industry I suggest three principal factors are needed . The first is equity capital. Equity capital for CDFI's is very difficult to raise, and appropriate Government participation, perhaps on a one to two match, could help induce private sector investment. Second, grant funding is needed to fund technical assistance for new or expanding community development related businesses or projects. Technical assistance is also needed for new CDFI's. Third, professional training programs will need to be created to help provide the staffing for a major expansion of the CDFI industry . Within the context of this discussion of CDFI's, I have two comments I would like to make about the Community Reinvestment Act. First, I believe that all of my colleagues in the CDFI industry agree that any Federal support for CDFI's should not cause a weakening of the CRA. We support full CRA enforcement. Also, it is entirely unrealistic, in my opinion , to think that the CRA will cause widespread bank support for CDFI's which could therefore substitute for Federal support. Banks already generally receive CRA credit for investing in CDFI's, but have only chosen . to do so in relatively small amounts. Most of that investment has been deposits or their equivalent, rather than the equity investment and technical assistance grants which are needed for the expansion of the CDFI industry. 10 I hope there will be more investment in CDFI's by banks , but Federal support is needed if there is to be any significant step up in the rate of CDFI formation and expansion . Turning to the CDFI's that I have founded, Community Capital Bank is a New York State chartered , FDIC insured commercial bank. Our bank has committed more than $7 million in loans and letters of credit so far, all of which are community development related. Approximately $3 million of this total is directed to multi unit affordable housing, while the other $4 million supports small businesses and nonprofits in low- and moderate-income areas of New York City. I am happy to tell you that the bank does not have a single nonperforming or delinquent loan so far. Our bank has received no Government subsidies of any type to date, nor, may I add are we asking for any operating subsidies . Our bank makes small commercial loans from $25,000 up to $450,000 or to $ 750,000 with an SBA guarantee. Let me sum up for you the competition in that market in lower income areas of New York City. We have had only two deals where we were truly in competition with another bank- I am talking not about just the loans that we have made but the loans that we have seriously considered . We have not lost any of our existing loans to another bank, and we have not taken a loan from another bank that was anxious to keep that loan . I would also like to briefly describe LEAP, Inc. , to you. LEAP started out of a recognition that a commercial bank cannot provide risk capital , meaning equity or seed capital . A bank may also have significant problems in providing intensive technical assistance , partly for legal reasons . LEAP is a nonprofit which fulfills these needs for small businesses that have a high community development potential, especially as to job creation. I refer to LEAP and similar organizations as venture development organizations . Finally, it is important that any legislation supporting CDFI's that may come about be flexibly structured . This is a young and growing industry whose needs are evolving. A responsive administrator of Federal support is equally important so that the process does not become so time consuming as to be effectively useless , especially for newly forming CDFI's . I urge that strong input from CDFI practitioners be incorporated into the administration of any Federal support to CDFI's . The best vehicle for accomplishing these administrative purposes may well be a quasi-independent corporation . I appreciate the opportunity you have given me to express my views on community development banking . A considerably more detailed version of my testimony has been submitted to you in writing. Thank you very much. The CHAIRMAN. Thank you very much . Let me just indicate, for the record , that a quorum has now been established, and has expressed itself unanimously in favor of Laura Tyson's nomination. We will leave that voting roll open for others I S 11 to be able to be recorded and she will be reported out favorably on that basis. Mr. Lopez, we are pleased to have you, and we would like to hear your summary now. STATEMENT OF STEVEN LOPEZ, PRESIDENT AND CEO, SOUTHSIDE BANK, GRAND RAPIDS, MI Mr. LOPEZ. Mr. Chairman, honorable members of the committee, I am really delighted to be here today as president of Southside Bank, to share with you why the members of that community got together to form the bank. They got together to form this bank because, for example, in 1989 , the established banks held $ 508 million in deposits in various commercial banks and savings institutions , and only about 1 percent of that was being loaned to members of the community for mortgage purposes. I find it very difficult to participate in a capitalistic system when you have no capital. In today's economy, when States are struggling with tax revenues-when you are dealing with a shrinkage for tax purposes because most of your employees are idle , employers are making sacrifices to save money, I think it would behoove the system to make sure that small businesses have access to capital . Because, without access to capital, small businesses are going to find it very very difficult to generate jobs . Like, for example, in the community that I represent, you are going to find minority contractors who have received contracts from the city, the State or the Federal Government, and they go to the banks and try to finance them. They have a difficult time getting it financed . Most of these people have to resort to family loans , if they are lucky enough to come up with family loans. So I recommend and suggest to this body that at a time when the United States needs to grow its economic base, it cannot afford to continue to ignore a major segment of its market. The African-American market, which is 32 million strong, in 1991 earned $300 billion . Unfortunately, we seem to be on the consumer side of the economy, as opposed to the supply side . And based on that, I would strongly suggest that we start looking at community banks as a way of shoring up the established banking system . I know a lot has been said about the Community Reinvestment Act. It has been my experience, and I am not here to bash the established banks, what has happened is that the Community Reinvestment Act has been looked upon as a safety valve for the major corporations , together with black organizations in the AfricanAmerican community, where it has provided the corporations with a safety valve. For example, the corporations have a way of making or underwriting events for black organizations, and the bottom line is that no perpetual mechanisms are being built. Also , financial institutions factories that will eventually make a difference in terms of helping the African-American community not only find jobs , but also give them a sense that they, too , can participate in the capitalistic system. And the only way we are going to change this is by changing the perception that African -Americans are only entitled to 12 entitlements , as opposed to fully participating in the capitalistic system . Right now, we are sponsoring organizations in Russia to teach them the capitalistic system. At the same time, we seem to be ignoring the potential of the 32 million African-Americans that we have in this country. And I think that we would all be better off if we would start teaching the African-American how to become fully partners in the capitalistic system . Thank you, Mr. Chairman. The CHAIRMAN. Thank you very much, Mr. Lopez. And I appreciate the observations you have just given us. Mr. McNamara, pleased to have you and we would like to hear you now . STATEMENT OF EDWARD H. MCNAMARA, WAYNE COUNTY EXECUTIVE , DETROIT, MI Mr. MCNAMARA . Thank you . Honorable Chairman and members of the committee, thank you for inviting me to testify this morning. In other testimony given today, and at previous hearings, you have heard representatives of Shore Bank Corporation discuss their work with organizations throughout the country who are exploring the establishment of development banks . Wayne County, MI, is one of those organizations . Why is Wayne County the Nation's eighth largest county with a population of over two million people interested in forming a development bank? The greater Detroit area, including Wayne County, has witnesses a tremendous shift of wealth over the past 30 years . A lethal combination of blight, disinvestment, and suburban sprawl has contributed to the decay of many neighborhoods across our county. Our older urban areas have been virtually abandoned as investment has moved further and further away from the central city. Urban blight has now touched some of our inter ring suburbs , yet we continue to push development further and further out into farm land. Essentially, what we are doing is throwing away billions and billions of dollars in infrastructure investments that we made earlier this century in our urban neighborhoods . At the same time, we are spending billions more to build new schools, roads, and sewer lines in greenfield sites . I am sure you will agree, Mr. Chairman , that this is a shameful waste of resources. As Americans are becoming more cognizant about the benefits of recycling, it seems we need to develop a strategy to rebuild our aging communities, house by house , block by block, and neighborhood by neighborhood. Our older communities in Wayne County face three basic problems . Nonfunctioning real estate markets , minimal job creation through business development, and a deteriorating social fabric. We have identified three communities in Wayne County as potential markets for our development bank : Hamtramck, Highland Park, and the East Side of Detroit. In each of these markets , real estate activities have essentially been nonexistent. 13 In 1989, only two mortgage loans were made for 1,000 housing units in Highland Park, compared to 55 mortgages per thousand housing units in healthy markets. The perceptions of crime, violence, and depreciating values has discouraged new investment in homes and businesses. Despite these perceptions, there are many signs of potential in these markets. The housing stock is very affordable, each area boasts a strong African-American population, and there are many active block clubs and community based organizations . Furthermore, there are numerous opportunities for economic development, both commercial and industrial. Our proposed institution would have three operating units: A commercial development offering conventional bank services ; A real estate development arm to focus on housing, commercial and industrial development; And a not-for-profit affiliate which would provide non- bank business credit, business support services , and housing assistance. The investment and credit activities of the bank will be complemented by these other two units which can initiate development projects and mount a coordinated revitalization effort. The bank will inspire prospective homeowners to purchase homes in established neighborhoods. It will nurture the entrepreneurial spirit by encouraging ma and pa rehabers. And it will encourage other investors to pump money into newly stabilized neighborhoods, therefore generating jobs and opportunities for local residents. The economic challenge facing our older communities will require some heavy lifting. A development bank will need to work together with conventional lenders and private and public sector leadership . All of the bankers with whom we have met to discuss the development bank concur that development banking is a niche business that complements conventional banking. Since we began discussing the business plan with individuals from the private sector, we have received many calls from individual bankers expressing their support for our efforts. As government, we at Wayne County have had to recognize our limits in the creation and operation of a development bank. We can be the convener but cannot operate, control, or influence an entrepreneurial private sector development bank without constraining its ability to respond to changing marketplace. In the document we submitted for the Congressional Record, we recommended the committee keep in mind certain guiding principles as it drafts legislation . And to summarize these principles : We believe the fundamental premise of a development bank as an entrepreneurial adaptive organization must be preserved. We do not believe a separate regulatory structure is necessary. Because of the significant organizational and legal costs , we believe grant funding should be allowable for start-up costs , and matching Government funds for private capital commitments will allow a development bank to build a sound capital base. We have been talking about, what we have done , in effect, is to plagiarize, from President Clinton's campaign theme, a theme that we believe applies in this case, and we truly believe that it is the neighborhood's stupidity. 14 In conclusion , this county has established public purpose , permanently capitalized professionally managed institutions to carry out activities important to society. Museums , hospitals and universities are all examples. And now it is time to create similar institutions for urban neighborhoods. After 2 years of extensive planning and research, Wayne County is prepared to launch the first community bank of the Clinton administration . Thank you, Mr. Chairman. The CHAIRMAN. Thank you very much . As we start down through the questions here, I am going to, for those Senators that were not given the chance or were not here to make an opening statement, we will provide a little more time in their period so they can do that. Because I know particularly Senator Moseley- Braun has a comment I am sure she will want to make with respect to Chicago's experiment . I know Senator Domenici has expressed a special interest in this area as well. Let me just ask you several questions at the outset. It seems to me that I am very strongly in support of the Community Development Bank idea. I think they are by their nature hard to make happen, because you have got to have a committed pool of talent that can sort of come together and assemble resources , and with the support and blessing of governmental institutions get off the ground. I am struck by the fact, as to the study that I have done on the South Shore Bank that you have been very favored over a period of time by having an extraordinary team of leadership represented importantly by yourself and your colleagues there. I have asked myself this question : If you subtract that extraordinary team of people that over the years now have made this the success that it is, and have nurtured it and have brought it along, could it otherwise have happened? In other words, would the concept succeed by itself if you did not really have an extraordinary team sort of making it happen? I am going to ask you in a minute to comment on that, but I have drawn from it at least in my own mind, subject to what you tell me, that you really do need quite an extraordinary team, and they have got to be tough, and they have got to hang in there over a period of time because these are not simple issues to resolve and to get the momentum and to sustain the momentum. I am also interested in the degree to which we run any risk here of the traditional banking institutions who have not done very much yet anyway in many cases-not in all, but in some-of doing a sufficient amount of community based lending. There is a lot of mortgage discrimination and other lending discrimination we know from Federal Reserve studies. I am very much concerned that I do not want to see a burst in community development activity allow the traditional banking system to back away or to maintain an anemic commitment to urban and community revitalization. I think we need them involved far more than they have been involved . At the same time, we foster the development of Community Development Banks to come along and do some of the niche-type work that has been described here. So I think we need both . 15 Now, Mr. Davis, let me start with you to ask you to react to both of those points, ifyou would. Mr. DAVIS. Well, if I could take your second question first, because it is really the easier. As I said in my statement, the work of Community Development Banks and of the larger regional banks should be complementary. In our case, for example, we are a small institution. The bank now has assets of just in excess of $200 million. The CHAIRMAN. Over now what time period? It has taken you how long? Mr. DAVIS. We bought the bank in 1973. This is a 52-year-old bank, incidentally. The CHAIRMAN. Right. Mr. DAVIS. It had tried to move from the neighborhood, was denied that request by the Comptroller of the Currency which regulates national banks as you know. The CHAIRMAN. Right. Mr. DAVIS. We then went in to talk to them about purchasing it with the idea of keeping it there. The CHAIRMAN. Right. Mr. DAVIS. It was then a $40 million institution. The CHAIRMAN. If I could just stop you, so it has been literally a 20-year climb? Mr. DAVIS. In August of this year we will be 20 years old as a development institution ; correct. So we do not view ourselves as competitors for the $30-$40 billion institutions in this country. The CHAIRMAN. Right. Mr. DAVIS. There is no way that we can compete with the First National bank of Chicago. However, we are in need of support from the larger banks. Our real estate subsidiary, for example, borrows very heavily from the large banks in Chicago to do its projects, which we could not do unless they were there to provide that pool of credit. So there is a lot that the larger banks can do in support of these niche-players, and you have to be a niche-player to make this work. You have got to be in the neighborhood, know the market, and there is a market in every single community in this country. It is just dysfunctional in a lot of cases at the moment. The CHAIRMAN. That is right. Mr. DAVIS. So we need to help restore that. You have got to be in the neighborhood every day doing your business to learn that market and make it work. Our hope is that we can then say to the larger institutions: We are here. We know this market. Help us provide the kind of credit that is needed. On your first question about individuals, it is true that our interest grew out of the fact that the four of us who now form the management team for South Shore had all worked in community development organizations in prior years and had seen the extreme difficulty that those organizations had in trying to do their work. Most were concerned with how were they going to keep the lights on next weekThe CHAIRMAN. Right. Mr. DAVIS [continuing]. Or how were they going to pay the utility bills? And they did not have time to look at the real problems that 16 they were trying to address. We concluded that a permanent institution organized specifically for development was the way to go. I think if you may recall, in the 1970 amendments to the Bank Holding Company Act the Federal Reserve Board itself stated that in their opinion bank holding companies possessed a unique combination of managerial and financial resources with which to deal with the Nation's social ills . We concur in that. Specifically, just one quick example which I think illustrates how this works. In the area of housing we have a not-for-profit and a for-profit real estate company that does housing rehabilitation . They go in and do large-scale projects: 100, 200 units. That enables the bank to come behind them and loan to private individuals at market rates who are interested in investing in housing rehabilitation and improving the neighborhood. As of the end of last year, we had caused 30 to 35 percent of the housing stock in this one neighborhood, the rental housing stock, to undergo some form of rehabilitation. Our development companies use Government subsidies for their programs. But for every unit of subsidized housing that gets produced in that neighborhood , we produce 42 units of unsubsidized . That is the kind of leverage that I think development institutions can bring to bear. The CHAIRMAN. Let me just say before yielding, it seems to me, again with this 20-year march that you have made as an institution starting after you took over the bank with $40 million I think you said in assets and you are up to $200 million now, it has taken 20 years of sweat, and vision, and hard work to do that. I think I draw from that the lesson that: As powerful and as valuable as this concept is , we cannot just speak it and expect that 1,000 flowers will bloom, that it is going to take a comparable effort and support from the rest of the system. We cannot have the rest of the banking system saying: "Boy am I glad this community development bank is coming down the track as this will relieve us of our CRA responsibility, and we will let them tackle the hard problems and we will go out and sort of cherry-pick the credit market." I think what I am hearing you say is that these things really have to work in tandem if we are going to really start to break the strangulation of credit that is not getting into our inner cities , to minority people, and to others who have the-I mean, to be peddling capitalism in the Soviet Union and not doing capitalism in the United States to me seems to be absolutely upside down. Mr. DAVIS. I think so . Two responses . One is , we are much smarter today than we were 20 years ago about all of this business . I think we have now in fact moved to a second Chicago neighborhood. The pace at which redevelopment is occurring is much faster than it was when we were sort of the first people out there by ourselves in Chicago . I would like to re-emphasize, I think one thing you said— and this is not a quick-fix to this problem-if there is one thing that this has taught me, it is that when I started I had no gray hair. I now have prey hair. [Laughter. ] Senator D'AMATO . At least you have hair. 17 [Laughter.] The CHAIRMAN. Well, and we have asked you to be our lead witness because you bring great wisdom and experience, and we need to draw upon that, and we are doing so. Mr. DAVIS . Thank you. The CHAIRMAN. Senator D'Amato. Senator D'AMATO. Mr. Chairman, I would like to piggyback on something said earlier and try to understand from the people who are out there on the battleline, why would it not be a good idea to give credit to institutions who indeed give you the credit and the capital that you need to continue your work? You are the specialists. So why should we not say, for example, if xyz bank has $ 150 million in capital itself and is in a suburban area where there may not be the kinds of needs and demands , where they do not have the kinds of specialties that you have developed by being in the community as every one of you have indicated, and why should they not be able to take 3 percent of our capital, or 4 percent of their capital and invest it in your bank? Mr. DAVIS. I support that 110 percent, Senator. In fact, we have suggested that and are now in a process in Chicago of trying to get the larger because we need more capital to grow-we are trying to get the larger banks to buy stock in Shore Bank, and for that they would get CRA credits. Senator D'AMATO . Yes? Mr. COMSTOCK. Yes, Senator, if I could respond to that. First of all I think it is important to understand that it is generally regulatory policy already to give CRA credit for these type of investments. So I do not think you need to take new action in order for that regulatory policy to be in place. I mean, there are a lot of bank regulators , but in general that is policy already. The question is Senator D'AMATO. Let me suggest how we can open that up and get you more. They get no relief from the regulatory requirements in reporting. So consequently, if a bank gives you 3, 4, or 5 percent-and they can only go up to 5 percent and we might look at that of their capital, what you do is encourage them, because they save x dollars per annum in not having to meet volumes of paperwork because they are actually investing, and they can say that $5 million in capital or so is invested with you. Mr. COMSTOCK. Could I make a little further response to that? Senator D'AMATO . Yes. Mr. COMSTOCK. I am a banker, not a public policy person, but it seems to me that there is a very fundamental issue about CRA that maybe the Congress has to think about-which is the fact that there has never been standards set for CRA. Part of the bottom line here is that the regulators do not know, and the banks do not know what is an acceptable performance on CRA. It may be that Congress has to look at that question of what is an acceptable performance on CRA in order to be able to come to a solution to this question. Senator D'AMATO. All I am suggesting to you is that if these banks meet certain capital requirements that they invest with com- 18 munity development banks such as yourselves, and others who have the expertise and get a double bang. You are getting capital that you never would have gotten before . They are getting expertise at bargain rates. They are getting the best in the business, people who are there, and they are also relieving themselves of that reporting requirement. Yes, Mr. Lopez. Mr. LOPEZ. Senator, I would like to share with you also that some of these banks know that they can invest 4 percent of their equity into these community banks, but some of them blatantly refuse to do so because they see these small banks as competitors . You also have to take inSenator D'AMATO. Let me set it up this way so that you understand fully. What we would say is that unless you put x dollars in, you have got to meet CRA. You have to then go through that, because then there is a presumption. We want to see what you are doing as it relates to your loans . If you put that 3, 4, 5 percent-I don't know what the number should be-then there is a presumption that you have met your responsibility by virtue, prima facie, of giving that kind of contribution to a community development bank. What do you think of that? Mr. LOPEZ. Yes, but the point is, as I said earlier, that they are aware of this but in some cases they just refuse to do it. Senator D'AMATO . Right. Mr. LOPEZ. OK? They refuse to do it. You also have to understand that bankers bring their cultural biases to their jobs . You have bankers who pretend that they have never seen Black people, or Hispanic people. There is no way that I can hide the fact that I am an African-American. From the time I step through that door, you know who I am. What bankers are doing these days is they are not recording applications that they are taking in from minorities. You walk in with your application, and they give you a verbal turndown . So when the regulators come in, they see that xyz bank took in eight applications and turned down two, and this is why you have some of the inflated rating that you have. Senator D'AMATO. Mr. Davis, what do you think about us setting it up as an alternative? Do you think that would promote a great deal more investment? Mr. DAVIS. I have a couple of responses . I truly believe that most bankers in this country are not racists. I really believe that . I do know and believe that this is a market with which they are not familiar. Like all of us , if it is something we do not know well, we tend not to understand it, and we avoid it. So what we need to do is to try to move to an arena which gets a fuller understanding of these markets to those bankers . I think there is no better way than investing in a small community institution whose business is this. With Mr. Lopez I think I disagree, that we are not competitors. There is no way that a small bank can compete with a mega institution. It is a different world. What we need to do is to work toward what is the arena in which we can do our job best, and where they can be most supportive . M 19 And on the issue of CRA, I think the fault with it now: when CRA was passed , South Shore Bank was the only bank in the country who came here to this city to testify in favor of it-the only one. What is wrong with it I think is that it is a punitive thing. It says to a bank, if you do not do this, then we will not let you buy this bank over here, the branch. What one should be doing instead is to provide incentives, which is what I think this is, for them to do so . Senator D'AMATO. Exactly. You got my point exactly. I hope we can get out clearly that what we are trying to do is to provide encouragement for people to meet this responsibility and go beyond it bring that critical capital. We are talking about hundreds of billions of dollars capital that can be flowing into those poor neighborhoods. I think we can really make it the kind of thing where banks will be happy, the larger institutions, to be able to meet this opportunity and their social obligations and their financial obligations, and not have something that is now very punitive and detrimental. Mr. DAVIS. And just another point, the leverage is enormous. For every dollar of capital that a large bank would invest in Shore Bank, it allows us to put $15 on the street. Mr. COMSTOCK. Could I make one further point here? I think I do not have any problem with the general line of thinking that you are going on, Senator. We certainly would like to have more bank investment in our entire industry. Senator D'AMATO . That is right. Mr. COMSTOCK. We encourage that. And we have some already. Morgan Guaranty, for example , is a shareholder in our bank. I think one of the questions we are going to have, though, is if you are talking about this as being an alternative to CRA, whether this is an appropriate standard . Five percent of capital is going to translate to roughly one-half of one percent of assets for a bank. Is that an appropriate level? That question I do not think has ever been addressed by Congress that I know of: What is an appropriate level of total bank Toans, or total bank assets that ought to be going into CRA? I think most people are going to end up feeling that half of one percent of assets is not adequate. Senator D'AMATO. Let's look at this. My time is over, but you are getting right to the core of the issue. Banks are still going to be making lots of other loans . The fact that you now have a relationship with Morgan, and you might then have one with Chase, and who knows who else , then they are going to be doing other kinds of business with you . Morgan probably has already been doing more business with you as a result of that and taking on some of the bigger loans, or participating, and that is the thing that Mr. Lopez is discussing. It brings people together who heretofore have not been together. So think about it. The CHAIRMAN. Let me, if I may, given the pressure of time, the late start, and we have got another panel, if you will indulge the Chair for a moment, Senator Moseley- Braun of course is directly relevant to the story that we are talking about in Chicago , and I know you must leave to attend to another assignment in a moment, 20 so I will interrupt the order to just allow you to make comments that you wish to make right now, and then resume the original order. Go ahead. OPENING STATEMENT OF SENATOR CAROL MOSELEY-BRAUN Senator MOSELEY- BRAUN. Thank you very much, Mr. Chairman and I will be brief. I would like my prepared statement to be placed of record . The CHAIRMAN. Without objection . Senator MOSELEY- BRAUN. I would like to thank you, Mr. Chairman not only for allowing me to break in the order this way, but also for calling this hearing so early in the process. This is a tremendously significant area. It I think lies at the very heart of our efforts to redevelop our country and to put our people back to work, to reclaim our neighborhoods, and it is probably the single most important area in my opinion that we can move in terms of the urban agenda. So I want to thank you for putting this first in terms of our hearings . I am particularly proud of Mr. Davis. Not only are we personal friends, but we go back 20 years. I felt old , Milton, when you said it was that long. [Laughter. ] Senator MOSELEY-BRAUN. I go back to his efforts in the South Shore community, and that is of course where I live in Chicago. I remember when we were all very young, bright-eyed and bushy tailed, young people starting out. I was in Government and Milton was in banking, and we had such great hopes for the future. Well, the future is now, and I am just very proud to see you here testifying on behalf of what is a successful, laudable experiment that has been taken up nationwide. I just wanted to express that to you before I leave. I am going to try to get back in time. I understand the Chairman is going to plow through with the hearing and continue, because the areas that you touched on , particularly as regard to the CRA, and Senator D'Amato's questions, is just so critical to our understanding of the approach and the direction that we take. So again to all of you gentlemen , Mr. McNamara , Mr. Lopez, Mr. Comstock, and of course Milton Davis, I want to thank you all for coming this afternoon and for starting this ball rolling, and starting this level of conversation , because we need your help in this regard . Thank you again . The CHAIRMAN. Thank you , Senator. Senator Boxer. OPENING STATEMENT OF SENATOR BARBARA BOXER Senator BOXER. Thank you , Mr. Chairman. I would like to get the panel's reaction to a very important event that occurred a little over a week ago in California when the Sumitomo Bank of California agreed to provide more than $ 500 million, a full 10 percent of its assets , for home and community development loans to neglected areas in California . The bank, as have others in California, has been criticized for its failure to make enough loans to minorities in the inner-city. 21 For example, in 1991 Sumitomo made only two loans to AfricanAmericans and 6 to Latinos out of 180 total home mortgage loans. Unfortunately in California this is the story over and over again in every area. Now my understanding is that Sumitomo's commitment is the largest from a Japanese controlled bank; it begs the question I believe Senator D'Amato is pursuing, the question of how best to ensure that capital-starved areas are Federal. Here, with Sumitomo, we have a bank that is under a lot of pressure from the community and agreed to this very big contribution. As I listen to you-and you have all been eloquent-it's clear that one of the strong points of a community development bank is its location in the neighborhood; you keep your eye on the problems , you are out there with the people, and you know what is going to work. My question is: Should there be a spinoff from traditional banks that only handles community development? Or can we trust that a bank that has never done this before is suddenly going to understand the needs of the community? Mr. MCNAMARA. Just from a practical standpoint, if I might comment, the South Shore Bank has proven that the concept works. They have for 20 years not lost money. So obviously it is not a giveaway program ; it is not a grant program; it is a business. But it is a business with a social agenda that is specific from that group . It is niche-operation , niche-banking, and I think that is what is extremely important. If we are going to bring back the inner cities, the communities that have been so blighted, it is as I mentioned a house-by-house, block-by-block, neighborhood-by-neighborhood action , and I am not sure large banks that you are referring to have that kind of social conscience about them. Senator BOXER. So you would prefer to see community redevelopment spearheaded by a very special institution that oversees its needs, as opposed to having a large bank do it by themselves? Mr. MCNAMARA. I would prefer to see the organization that could be most effective to accomplish that end. I think it is niche-banking that has the best-the most stability to make it happen, rather than a large bank that would lose this process someplace in its total operation . Senator BOXER. Mr. Lopez. Mr. LOPEZ. It has been my experience that when the larger banks have a community development arm, that you continue to get more of the same. I would just like to say, to follow up on Senator D'Amato's question, like for example again I am confining myself to Grand Rapids where in the community I see qualified African -American borrowers in front of me, like for example Ms. Lambert here, who is a member of a board. She is a member of a board to the point where she has committed $60,000 of her measly savings because she sees the need for this bank- not only, herself having been denied loans , even though she is a qualified person who owns her own business, but she has associates who have been denied loans. 22 Like for example right now I see a gentleman in front of me who is a graduate of Northwestern University, who started a soda business. All the banks in the area turned him down. OK? When they turned him down, he went to them and said, OK, give me a second mortgage on my home. They refused to do that, too. Senator BOXER. Well, I do not mean to interrupt, except that I am on yellow here and I want the answer to the question : Do you agree that a large bank with a community development arm would not meet the needs of the community, as well asMr. LOPEZ. It would be more of the same. Senator BOXER [continuing] . A niche bank? Mr. LOPEZ. Correct . It would be more of the same. And I think the best way to relay this is to share with you an exampleSenator BOXER. I agree already. I am just trying to pin it down because in California we have got this big announcement, and it is very exciting, but I want to know if the organization should be changed to meet this need. Mr. COMSTOCK. If I could just make a quick response, I think the basic word is that our communities need all the help they can get. If Sumitomo Bank is willing to jump in and do it, let us encourage them in whatever way we can. I think they will find out very quickly that it does take a lot of expertise to do this work. Apparently they have not been doing it, and they are about to find out. One of the things the community development financial institutions are trying to do is actually provide the know-how that is going to help leverage this lending. I think it is absolutely the case that we are functioning just as Mr. Davis has just described to try to help leverage more conventional bank lending into these neighborhoods . I think the role is going to actually be complementary, but they will soon find out that they are going to need a lot of expertise and will have to turn somewhere to get it. I do not know that we have to tell them legislatively that, you should not do this; I think we should just try to encourage them. Senator BOXER. Mr. Chairman , could Mr. Davis just answer that? The CHAIRMAN. Sure. Go ahead, Mr. Davis. Mr. DAVIS. I think it is a good question because-and it seems it me the bottom line is whether the money that has been committed gets out into the neighborhood. Senator BOXER. Right. Mr. DAVIS. And I do not care whether it comes from them at their big office downtown or someplace else. I think I would argue, however, that if they committed and then expect to do it from downtown, it will not happen. If you look at all the mortgage disclosure information that revolved around the issue of discrimination , it was because people were trying to do these programs from their downtown headquarters, and they were being serviced by people who had been trained to look at credit in a different way from the way I think you have to look at it in the neighborhoods. I have always thought of States like California being the optimum place for this because you could simply take a branch that was located in a low- income neighborhood and turn it into a devel- 23 opment institution and staff it with people from the neighborhood who know their neighbors , and know the market, the local market of that community. You would not have to form anything new. It is just that this branch becomes this specialized niche-player in this market where you have people who understand the economy of that community and the people in it. So it has to be done in some way where there is a local presence by this bank to make sure that the credit gets out. Senator BOXER. Thank you so much. That was very helpful. The CHAIRMAN . Thank you very much. Very useful. Senator Bennett. OPENING REMARKS OF SENATOR ROBERT F. BENNETT Senator BENNETT. Thank you, Mr. Chairman. Mr. Davis, I will talk primarily to you, but I would be delighted to hear the others comment, as well. You made the comment about replication, and you said talented people with start-up support can do it. That is my big concern . You are kind of a hero. South Shore Bank has caught everybody's attention, and it has been written up, and gotten lot of press. As I sit here, I find myself thinking. If I were not under the kind of strictures that the Ethics Committee puts on us, I might be interested in investing in your bank. Mr. DAVIS. We would welcome you . [Laughter. ] Senator BENNETT. I know you would. [Laughter.] Senator BENNETT. But my interest comes, quite frankly, not from your social conscience that I have heard people talk about, saying the banks will not have the social conscience to do this; my interest comes from the fact that you have made money. The entire economy is filled with companies that find a niche that bigger companies have overlooked and have filled the niche and have made money in the process. I wrote myself a note : "It is not social conscience; it is good management that makes this work." And as I hear you explain things in answers to the questions, you always come back to that theme: We know how to do it. We have the expertise. This is a 52-year-old bank, you said. You did not start up something with a social conscience dream. You saw as a manager an opportunity that the existing managers were not smart enough to see, and you bought the bank, and you made money on it. I salute you, and I wish we could replicate you everywhere. My one concern in these hearings is: How are we going to do that? At the Federal level, what can we do that can produce the kind of management ability and expertise that you have? Standing up in here and saying "we salute the concept" is not going to produce the kind of managers on the street that will make this happen. So I would like some comments from all of you about that particular problem. Mr. Davis. Well, a couple of comments. 24 One is: Today we are now operating, or are at least under contract, with different owners of the development institution in Arkansas, which is where the now President first became familiar with this . We have, as the gentleman here said, we have been-we are now talking to people in Wayne County, but we actually have an institution in the Upper Peninsula of Michigan headquartered in Marquette that is beginning to do this kind of activity in conjunction with people who came to us from that section of the country because they wanted to do this same kind of thing. In this case , it is not a full-blown bank. Senator BENNETT. So far you are proving my point. "You" are doing it Mr. DAVIS. No, we are notSenator BENNETT [continuing ]. Because of the expertise you accumulated . Mr. DAVIS. We are helping them. They came to us, and we helped them think through the business plan. We have an advisory service which again we set up partly to help spread the word as to how this is done. But back to your point, it also is another source of profits for us. What we do is consult. We are now talking with 12 cities : Cleveland, Milwaukee, Portland , Louisville-about development banks . So they hire us to help them develop the plan as to how this ought to be organized and run. Now in Arkansas we were able to send one person from our staff who had been trained there to go and be the president of that institution . But it cannot work that way. I mean , we just cannot- we are too small to provide training for all the people that are needed. But part of what I think Mr. Comstock was saying is that part of this could be money for training. People can be trained . There are smart people around this country interested in this issue who can be trained . There is nothing holy or sacred about banking. It can be taught, and there are smart people who want to learn it. If we had the resources with which to teach them, we could do it. That is where I think you will get the people that you will need to staff these banks. Senator BENNETT. Let me ask Mr. Comstock a question about the success of things you say. You are also the chairman of LEAP, Inc. , a nonprofit venture development organization with its office at the bank. Mr. COMSTOCK. Correct. Senator BENNETT. Is that an essential part of the economic viability of these efforts? Mr. COMSTOCK . Yes . Senator BENNETT. Would the bank not work if you did not have that? Is that another piece of the expertise that you bring to the table? Mr. COMSTOCK. I am not saying that the bank would not function. I mean, there are a lot of loans that could be made in the community. But in terms of an overall community development strategy, we very much agree with South Shore's concept that 25 there are a number of different pieces that are needed to make any economic development work. I would point out in particular that the need for equity capital is at least as great as the need for debt capital in our communities, and banks are not the vehicles to provide equity capital. Senator BENNETT. I have started enough businesses that I know exactly what you are talking about. Mr. COMSTOCK. The idea of LEAP is that it is kind of the leading edge of the bank. The bank cannot work with people until they are bank-able. How do we help get the community development related businesses, the businesses that are doing job creation in low-income communities, formed and stabilized to the point where they become bank-able, which means intensive management technical assistance, plus finding equity capital for them. So that is very much a part of the overall issue here. Mr. DAVIS. Could I just endorse that a little stronger than Mr. Comstock did? There are three nonbank subsidiaries of our holding company. It owns the bank, but it also owns a for-profit real estate development company. It owns a venture capital company, and it owns or there is affiliated it that is not-for-profit. I think we could never point to the success in South Shore if it had not been for those nonbank entities. The bank alone simply cannot do it. The complete development entity has to include those nonbank subs . Senator BENNETT. And that is, again, the part of the good management you bring to the table. Thank you, Mr. Chairman. The CHAIRMAN. And the question of whether you can compress this 20-year growth now with their know-how and experience down to a time frame so that we get an answer to the problems within the lifetimes ofthe people-I mean, we are going to need the expertise that you bring, as well , in terms of this view. I think both the other witnesses wanted to respond, and then we will move on. Go ahead. Mr. LOPEZ. Mr. Bennett, that is a pretty good point. I think talent and skill is really an essential ingredient, once we capitalize. One of the things I am critically looking at is to make sure that we have a comptroller that is versed in banking, because he has been a comptroller in one of the banksSenator BENNETT. You mean a Comptroller of the Currency? Mr. LOPEZ. No, a comptroller of the bank. Senator BENNETT. OK . Mr. LOPEZ. Also, the point I am trying to make is you are going to have to go with seasoned people. Regardless of their color, you cannot confine yourself to ethnicity. You are going to hire people because you are satisfied that they are capable of doing the job. The CHAIRMAN. Mr. McNamara, you wanted to make a comment? Mr. MCNAMARA. Yes. I would just like to comment relative to that. You know, we are a governmental unit, and we are talking about establishing a bank, and probably the worst group in the world you could have going into the banking business is a governmental unit. 26 , But the approach to this is to form a founder's group . The founder's group are people like Heinz Prechter, who is chairman of the American Sun Roof; Wayne Dorne, president of Ford Land Co .; Don Barden, Dave Bing who is a businessman and at one time was a great basketball player at S. Martin Taylor. These people would become the board of directors. They would run this as a business. The county would stay in until these people took over. Then, like the Communist Party, we would wither away and turn the operation[Laughter . ] Senator BENNETT. I hope not like the Communist Party. [Laughter.] Mr. MCNAMARA. Well, the theory of the Communist Party. Senator BENNETT. All right. Mr. MCNAMARA. But it is not a case of- it is a case of bringing the business community to run this thing with that social conscience as their objective. Mr. DAVIS. And I think, Mr. Bennett, also just a final point, some people have asked us why we did this as a for-profit rather than a not-for-profit. There is not enough philanthropic money in this country to rebuild cities . We could give up now. We have got to begin turning the thinking around that they are good places to make investments, and investments on which you will get a return . I think once we have demonstrated that you can make a profit doing this, we describe it as a lot of the really hard money of this country will begin to then flow into this process. Senator BENNETT. And you begin to attract investors like me. Mr. DAVIS. Good. Senator BENNETT. Thank you , Mr. Chairman . The CHAIRMAN. Thank you very much. Senator Shelby. Senator SHELBY. Thank you, Mr. Chairman . Senator SARBANES. Mr. Chairman , would the Senator yield? Senator SHELBY. I would yield to the Senator. Senator SARBANES. Could I be recorded in favor of the nomination of Laura Tyson? I gather we are reporting that out this morning? The CHAIRMAN. Yes. You will be so recorded . Senator SARBANES . Thank you, very much . The CHAIRMAN . Thank you . Senator SHELBY. Mr. Chairman , thank you . How can the Federal Government best expand the role community development organizations? For example , is it the provision of the patient capital that is needed to support community development reforms? Is it capital and management? Or management and capital? I believe you have got to have capital, and you have got to have management. If you have capital and you have inadequate management, we know you are planting the seeds of a disaster. What are your comments? Mr. Comstock, you look eager. Mr. COMSTOCK . Thank you. I think there is quite a substantial existing talent pool already to build on. We have actually more than 300 community develop- 27 ment financial institutions in the country. It is not just the four development banks. So one of the first starting points is to realize that we could expand upon the capacity of that group. I think anyone who looks at it closely would say that that group is doing a good job at what they do, and their impact could be increased if their capacity could be expanded. What would it take to expand their capacity? More equity is number one. Senator SHELBY. By equity, you are talking about money? Capital, right? Mr. COMSTOCK . Capital. Equity capital. For the for-profits, some form of shareholder type of capital. For the nonprofits, equity grants . But that equity base is the first starting point in terms of expansion of capacity. The second point is that in terms of economically devastated communities , communities that are heavily disinvested where there is a very low level of business development and economic development taking place now, there is a lot of technical assistance and hand holding needed to get that process going. That is inherently something that is not self-supporting and needs grant funding. The third thing is : As Mr. Davis had suggested, we could increase the talent pool if we had some support for professional training programs . Senator SHELBY. Should we give CRA credit, or consider giving CRA credit to other banks to have them train people? Because management is so important to any organization . Mr. Davis. Mr. DAVIS. I would vote for that overwhelmingly. I think there are a range of– Senator SHELBY. That makes sense, does it not? Mr. DAVIS. Pardon? Senator SHELBY. It makes sense , does it not? Mr. DAVIS . It makes great sense. I think there are just a range of things that could be done. The need at the moment I think is for somebody to do the appropriate level of work on the kinds of things that it would make sense to do so that, based on the experience we have had, that we can move closer to believing that these are things that would truly work. In the more extensive version of my comments today, there are some of those things being suggested that we have to look at . I think , like all things, some of them will turn out to be good ideas , others will not work. But we need to do the work that is required to see whether or not those would work. But I think training-I mean, it would have to be differently from the way the large banks do it now, because you really want to train people in this development arena . But they certainly have the resources with which to work to pull that kind of thing off. Senator SHELBY. And they could train them in a special niche which you are serving in the community. Is that correct? Mr. DAVIS. Right. Precisely . Senator SHELBY. Mr. Lopez , if I wanted to start, or help some people start a Community Development Bank in my State of Alabama, what would you suggest? Capital and people, I am sure. 70-832 O - 93 - 2 28 Mr. LOPEZ. Well, capital and people, and I must remind you that we have a lot of unemployed bankers out there. [Laughter. ] Senator SHELBY. They would probably be diligent workers if they were re-employed; right? Mr. LOPEZ. Correct. Absolutely. But I couldn't emphasize that more, that it is an arduous process when you have very limited capital. So whatever assistance can be given in tandem with getting a good talent pool, identifying a talent pool. My only comment is: I would be a little reluctant to give banks credit for training people unless I can get some commitment from them within a certain parameter. I just would notSenator SHELBY. Why not? Who could train them better than actual banking experience? The Federal Government should not be training them . Mr. LOPEZ . Well what I would do is, No. 1 , I would identify a president of a bank who is capable of doing what he is supposed to do, and then let him go out and find the support talent that is needed . Senator SHELBY. OK Mr. McNamara, you mentioned in your statement: The organizational and the legal costs for a Development Bank are quite significant, you know, for start-up, preparing management, and preparing fund raising. You have got to get the capital . That is a formidable task, is it not, sir? Mr. MCNAMARA . Absolutely. Senator SHELBY. Any suggestions there? Get your core group together, management first? Is that what you do? Mr. MCNAMARA. No, we have notSenator SHELBY. OK Mr. MCNAMARA. I think you do things like determine the neighborhoods where this process will work. We have brought together people who we consider very competent who would become in a sense the Board of Directors of the founders. We are attempting now to identify sources of private dollars from Foundations. We have had discussions with major banks in the State of Michigan who are extremely enthusiastic and positive about this. It may be a form of conscience money, but we do not care what motivates them. we would like to see it flow. The management will come, but I am not sure that that is the initial concern on our part. Senator SHELBY. Oh, the initial concern I suppose is the concept of how to put it together, and without the capital management you will not need the money? Mr. MCNAMARA. That is correct. Senator SHELBY. OK. Any other comments? Mr. COMSTOCK. That seed capital is very hard money to raise. You have got a good point, that organizing a new bank, typically, it is up to 15 percent of the amount of capital raised that we spend on the total organizing costs of the bank . I am talking about any kind of bank, community development or otherwise. In this case, since you do not have a small group of millionaires forming the bank, which would be the typical case in the typical small bank, you are going to have a hard time raising that seed 29 capital . So grants for that purpose are going to accelerate the process of formation of these banks . The CHAIRMAN. You know, my-if you would yield? Senator SHELBY. I would yield, Mr. Chairman. The CHAIRMAN. Might we not also think about maybe I mean , I like the incentive approach . We are talking about change in some capital gains treatment, and capital gains treatment based on holding period. There might well be a way to incentivize through the Tax Code a greater flow of equity capital into this kind of thing to achieve a strategic objective for the country. I mean, it is not a novel concept to try to target and do something that you need, as long as it is done competently, and because we are going to get the money back. We are going to get the money back in economic growth and revitalization by some multiple of what it is we spend. I mean, this is precisely the path intelligent nations have to take. Anyway, I do not want to trespass further. Senator SHELBY. Mr. Chairman , that is a very good comment. One follow-up on it. Mr. Davis, is there any competition or any overlap between the commercial bank in an area trying to fulfill the mandated CRA and what you do in a niche? Is there any overlap there, or some competition? In other words, say a commercial bank in Chicago serving the same neighborhood that you would be, they compete within a niche? Mr. DAVIS. Unfortunately, this is an area of when we went to South Shore it had 80,000 people in the community. Senator SHELBY. OK . Mr. DAVIS. We were the only bank there at that time, and we still are the only one. Senator SHELBY. OK. Mr. DAVIS. But, I would hasten to add that we really are not talking about creating anything new here. The holding company is examined by the Federal Reserve Board. Senator SHELBY. Sure. Mr. DAVIS. The bank is examined by the State Banking Commission because we are a State-chartered bank, and the FDIC because we have insured deposits. And we think in doing this work in a glass bowl, so to speak, is what partly makes it very successful and we would not change that. So this is not a new institution. It is going to be subject to all the regulations that banks are at the moment. But I guess to answer your question specifically, we would welcome another Development Bank in this neighborhood, because I think this competition is the strength of what makes this country run . And that needs to be brought to this arena. As I said earlier, we are not looking for charity or for grants. We have got to get these markets functioning in these neighborhoods so that none of the special sort of stuff is needed again; that it then moves just as the rest of this country operates , under regular, normal market forces operating in those places. Senator SHELBY. Are you giving people in the inner cities , or wherever you are operating, an incentive to save money, to invest, to put money in your account where it is available there that they did not have before? You were the only bank. 30 Mr. DAVIS. Well, we are-I am not sure we are doing that much to increase savings. Part of the purpose of what we do is we have the purpose of trying to increase wealth in these neighborhoods, because that is a big problem. I mean, there is no money there. A lot of what we are doing, we have a cadre of five or six dozen we call them ma and pa rehabilitaters to whom we loan to buy these large buildings to rehabilitate them. We are making an 80 percent loan -to-value for acquisition. We will do 100 percent of the financing for rehab. We will not do a loan unless there is a rehab component to it. We have, I am not ashamed to say, created through that process several millionaires within South Shore at the moment, and that is a part of what we want to do. Senator SHELBY. Thank you. Thank you, Mr. Chairman . The CHAIRMAN. Thank you. Senator Domenici. OPENING STATEMENT OF SENATOR PETE V. DOMENICI Senator DOMENICI . Thank you very much, Mr. Chairman. I too want to, right up front, indicate that I think this is one of the truly important areas that Congress ought to be looking at in an effort to see what we can do to help create wealth in some of our poverty areas and, as has been indicated here, to create entrepreneurs in the area, and certainly to create ownership. As I see it, as has been summarized here, we are not going to rehabilitate and revitalize our inner cities, or even our dilapidated rural areas unless we have something like this working with this kind of investment taking place. The Government is just not going to be able to do it all. It is going to have to be done by applying this concept of community development. I am here also to welcome a New Mexican, Pauline Nunez-Morales, who is sitting in the front row. Pauline, I am not sure when you testify if I will be here, but I will try. I think what you have to suggest by way of a small community organization in New Mexico that does some work in rural areas and relies on contributions from more or less charitable organizations to get your nucleus started is a concept that at least we ought to look at in terms of this overall picture, and I thank you for being here. Let me suggest, Mr. Davis, one of the things that is always difficult when we attempt to write laws or change laws to try to stimulate something that is working, that is a model and we want to expand it, and we know that its concept is very vital and really important, that we tend to try to have Government do the next step. No one in this institution is more concerned about small business and minority small business people as entrepreneurs in this country. In fact, I agree with the statements made here. You know, we do not have a fair society. If minority business people are not getting their fair share of loans and ability to accumulate equity when they have good deals , it is just not American . We are not going to fix the slums until that momentum moves in that direction. But it is not so easy to do. It is very easy to say we want to change. 31 Right now I would say, Mr. Lopez, small businesses that are not African-American are lining up at our doors saying they cannot borrow money. So the issue for the next few years is: How do we get bank money into small businesses? And in the process, what can we do to see to it that we do not miss the boat again when it comes to small minority businesses? The set-aside programs on contracts and the like is not the whole answer to this. I mean , the answer is to get loans and equity so they can have their own businesses and not be so dependent upon preferential treatment. Now having said that, Mr. Davis, I would support in a minute a set of laws that moved American business in the direction that you have just gone through, and that you now have in your Community Development Bank. What I am kind of worried about is: How are we going to write that into law so that we can duplicate your kind of activity all across this land? And what is needed from us to help with that? Right up front, I truly believe the concept of building profit into it as a motive is very, very important. You clearly cannot ask people to invest if they do not expect to get a return. You cannot expect bankers to be bankers if they cannot expect to make some profit. There may be a nonprofit role, but I truly believe the heart of this activity ought to be accumulating capital and equity from across America that wants to invest. In this instance, the invest is invest in a viable business organization or entity that they have a chance of owning, or sharing in, or making profits from. If you had to in just 2 minutes, if you had to define for us what would you change about the banking system or the current laws as you know them that would most probably cause more development companies like yours to come into existence in this country, what would those four, five, six things be? Mr. DAVIS. I think we touched on that earlier I think before you came in the room. No. 1 , Senator, I am not sure I would change any laws at the moment. In 20 years of looking at this, I would not. Where I think the help is needed is not in changing laws but in trying to think through what is the proper role of Government in something like this. I do not think it as doer, but I think it is as being supportive for those in the private sector who are attempting to pull this off. So I think, as Mr. Comstock said earlier, it is a matter of making capital available for the development of these institutions through sort of a third-party, not the Government investing directly. I can give you an example of that in which we are intimately involved . The U.S. Congress gave something called the Polish-American Enterprise Fund $250 million as a grant to spur economic business development in Poland . That was a grant made by this Government to that fund. When they received the money, they came to us and said: "We don't know much about small business development in Poland, for understandable reasons." We have now entered into a contract with the Polish-American Enterprise Fund to manage a small business loan program in Poland . We are in our second year of that. It has gone extraordinarily 32 well. There is almost $40 million that has been put out for small business development in Poland throughout the country. We have had two losses on that program, and am happy to say that in both cases we have recovered the full amount of those loans. So it is that kind of thing that I think is applicable to development banks, that some pool of capital is made available for a third party to administer that then gets put in the form of equity. Also there is money, as was said earlier, for training people who are going to run these institutions . Specifically I guess I would not change any laws because I think they are sufficient and appropriate for this kind of development. I would try to find the role that the Government could play vis- a-vis capital, grants, training funds to make these things happen . Senator DOMENICI. Mr. Chairman, I have just one suggestion that maybe our staff could do. It seems to me that we do have an awful lot of development programs in the Federal Government, and I am not so sure that they are all directed at the same target in the same itinerary of objectives such as Community Development Block Grants, Minority Business Development, Urban Development Action Grants , sometimes called UDAG, EDA- we don't have many more UDAG's, I understand . Through appropriations we have done away with them, not by law; so we just do not fund them anymore. But it seems to me we might take a look at how are they directed criteria wise. Maybe there ought to be more of a uniformity of criteria that directs them at community development, at least proportionately, if we want community development banks to be tied to community development programs . It might be an interesting source of resources . I gather that is sort of what you are saying? Mr. DAVIS . Precisely. The CHAIRMAN. And I might say that Mr. McNamara, being a county executive, has to deal with certain of those other programs coming through those other categorical avenues . Let me say, we are finishing a vote that started about 12 minutes ago on the Senate floor, so we must all go and vote, but I want to announce what our program is for the remainder here. Senator Sarbanes left early to vote. He will be coming back. He wants to ask some questions of this panel. When he has done so , we will then excuse this panel and call our next panel. I want to move right on forward, and while we are all here finish the work today and go through a part of the lunch period. I will appreciate everybody's indulgence in doing that because we are being interrupted by votes which we could not forecast when we established this. So we will stand in recess for a very short period of time until Senator Sarbanes returns , and he will reactivate the committee and he then will follow through . Senator DOMENICI . Mr. Chairman , might I say that I did not have enough time for each member, but I appreciate your testimony and I thank you very much. [ Recess .] 33 Senator SARBANES [presiding] . Mr. Davis, if you and Mr. McNamara could take your seats, I think we could get started again. Hopefully we will be able to finish with this panel shortly and then move on to the next panel . I know it has been a long morning. I am interested in this question: I guess ideally one would not want to have to set up special institutions or arrangements in order for credit to be available in these communities . Would you agree with that? Mr. DAVIS. I would, wholeheartedly. Mr. COMSTOCK. Yes, and I do not think that we are advocating a new class of charter or anything of that type. What we do need is institutions that have the desire and focus to work in these kinds of communities. Senator SARBANES. Well, do you think that we should go in the direction of setting up, or trying to set up these institutions who have the desire and focus to work in those communities and say to the existing institutions, well , you don't seem to have the desire or the focus to work so you go off and do what it is you want to do and we are going to figure out some other way to get the institutions to the focus we need. What is your reaction to that? Mr. LOPEZ. Senator, I cannot speak for Mr. Comstock and Mr. Davis, but I know the banking community where I come from in Grand Rapids is that I think we do need an institution in that area that is going to be sensitive to the needs of the minority business people and individuals as a whole. Senator SARBANES . Why should not the existing institutions be sensitive to that? Mr. COMSTOCK. I think they should. The issue has simply been that, in 16 years of CRA, we have only had limited success with that legislation in trying to force institutions that do not want to lend to do so. Now there are Senator SARBANES. Now would you say that your perception is that a real effort has been made to apply CRA? Mr. COMSTOCK. No. And I think that is one of the issues. If a real effort was made, which I think would have to start with setting some realistic standards for what CRA ought to mean, if such an effort was made , I think that would be good. I support full enforcement of CRA. I would not want to see the banks that are doing something now go back to doing nothing. That would be a step in the wrong direction. If anything, maybe they could do more. But I do think that it is always going to be difficult to try to get institutions- especially large institutions who do not want to do this work -to do it just to satisfy a Government regulation. I doubt if that will be the ultimate long- term answer for this problem, although I do not think that we should have them backing away from what they are doing now. Senator SARBANES. How much of a problem do you think that is , that the development of alternative institutions will become an in lieu of instead of a complementary or an in addition thereto? Mr. DAVIS. On your first question , I think that what 20 years has taught us is that in order to do this you must have an institution whose primary objective and goal is development. That simply is not the case with the large institutions , or at least the large finan- 34 cial institutions at the moment. Their primary objective is profits. With that going in, you are sort of off on the wrong track. I do not think anything I have said today I hope has not been looked at as inferring that the large banks should not be in this. This has not been their business for all the years that they have been operating. They do not know the markets in these neighborhoods. The last thing I would to happen is to have them forced to make investments in the neighborhoods, have them all go down the tubes, and then for the banks to say we tried this but it did not work. What I have been trying to focus attention on is to find the avenues through which the work of these community development institutions and the larger banks can be complementary so that we then-and I know in the case of South Shore, because we are in the neighborhood, on the ground, are willing to help them think through where they can play a role most effectively and where we will have success . Senator SARBANES. How long did it take you to get South Shore from ground zero to sort of where it was a viable, functioning organization? Mr. DAVIS. We did it in increments, Senator. As I said earlier, this is a 50-year- old bank. We bought it Senator SARBANES. It is 50 years old? Mr. DAVIS. Fifty years old, right. It was chartered in 1939. Senator SARBANES . All right. Mr. DAVIS. When the neighborhood changed racially, the bank wanted to move. The comptroller denied them permission to move it. So in 1973, a group of us who were interested in this issue of development banking were able to put together a group that bought the bank. We have only had ownership for now 20 years. But it was an ongoing institution , which is what we basically recommend for this kind of activity because there are a lot of problems you have normally with start ups, and so if you are going to try to start a bank with all the natural problems you are going to have, plus lay the development agenda on it, it is not impossible to do, it just takes you longer. We bought an institution that was relatively clean, without problems , that had a stream of earnings behind it. And so on the day that we walked in there, we were able to begin our development agenda. That bank located in the neighborhood was one of the many institutions with most of them in Chicago-who would not make a mortgage in that neighborhood, and they had not done so. The day after we were there, we announced that the bank was back in the mortgage business. So that is just an example that we started with that. Then as the years went on, we began to add more and more development products to that arsenal . Senator SARBANES. Now how long was it before people started coming around and saying you're doing such a fine job here that we want you to go elsewhere and tell about what you are doing, or hold you up as an example? Mr. DAVIS. Well , our original hope had been that we would demonstrate that bank holding companies could do this kind of activity and be profitable. WE 35 Then, naively we assumed that a lot of other bankers would come running to emulate it. That did not happen . Specifically in answer to your question, it was 10 years after we were there. I think a lot of people were watching just to sort of see if what we were doing was some sort of fluke, or whether it was real. So after 10 years of profitably doing this work, the neighborhood actually getting better, that some people began to say, well , maybe it is for real. That interest has increased. As I said earlier in my testimony, we are now consulting through our consulting company with at least representatives from a dozen other cities about establishing this kind of institution. Senator SARBANES. Now would you say that it would probably take others a comparable period, maybe somewhat less, to get into the same position? Mr. DAVIS. I think it would take somewhat less . Senator SARBANES. How much less? By a factor of what? Mr. DAVIS. I said earlier we are 20 years smarter about all of this than we were . We have a consulting company which we set up specifically for this purpose, for others who wanted to talk about how to do it. We are smarter about how one would structure an entity like this in another place so that, rather than going through the trial and error that we did, people can put in place more or less-I think Lyndon generously acknowledged the help that he had gotten from South Shore, or had seen at South Shore when he established his bank, and I think he would agree on the basis of having that experience of what we had done and our willingness to help him in any way we could-that he was able to move much faster. His bank is now three Mr. COMSTOCK. Two years old. Mr. DAVIS [continuing]. Two years old, and he talks about theI don't remember the numbers exactly, but in 2 years they have been able to do significant financing out of that bank for the areas in New York in which they operate. Senator SARBANES. I guess what I am concerned about , I have enormous respect and admiration for what you have done, and I would be happy to see it replicated anywhere we can do it, but I have some concern that the normal channels of activity in this area continue to be pushed to sort of meet their responsibilities . Otherwise, it seems to me the exceptions will not be the rule. You will just have the exceptions , so to speak; they will be trying to make the exceptions the rule, and that is a difficult process . It takes a lot of time, and there are a lot of existing resources out there. You know, the Federal Reserve Bank of Boston in a recent study found that after controlling for genuine credit concerns-this is after the control for the genuine credit concerns-minority applicants were 60 percent more likely than white applicants to be rejected for home mortgage loans . You have, you know, the Community Reinvestment Act came out. of in part the sense that financial institutions were drawing monies out of the community but not putting moneys back into the community, and this was an effort to try to get them to do that . Now- 36 Mr. DAVIS. I understand, Senator. I am sorry. I thought you were finished. The CHAIRMAN. Go ahead. Mr. DAVIS. I just wanted to respond that you are right. The large credit institutions are risk averse. But the one example I can give is South Shore. When we first got to that bank, or bought it in 1973 , there was not a financial institution in Chicago who would make you a mortgage in that neighborhood. Now, because we saw our role as getting out front and demonstrating that it was a safety place to make investments and actually making the market work, any financial institution in Chicago will now make you a mortgage in South Shore. That is the role thatSenator SARBANES. You mean in the South Shore area? Mr. DAVIS. Yes. Senator SARBANES. And they are now doing it? Mr. DAVIS. Yes. Senator SARBANES. To what extent? Is South Shore still doing it? Mr. DAVIS . To what extent is South Shore Bank? Senator SARBANES. No. To what extent are regular commercial financial institutions now lending in the South Shore area? Mr. DAVIS. Well, they are. That is the point I was making, that 10 years ago you could not get a loan of any sort in that neighborhood. Now you can walk into the First National Bank of Chicago , Harrah's Bank, those banks will make you credits in that neighborhood because of the work of Short Bank as a development institution we think has now made those institutions perceive that neighborhood as a safe place to invest, and they are doing it. Senator SARBANES. My question is: What percent of the credit in that area is being provided by South Shore as opposed to these other banks? Mr. DAVIS. I will give you-In the area of single-family mortgages, they are all being made by financial institutions because what we did, when we first got there, was to announce the next day, as I said earlier, that we were making single-family mortgages. OK? But we are a small bank. And because you can now get a mortgage at any institution practically in Chicago for a single-family mortgage, we have withdrawn from that market and now have put our attention on the larger, multifamily buildings where we are hoping that we can have the same results, that we will build that market to the point where we can withdraw from it, go off and do something else, andThe CHAIRMAN. Would you yield just Mr. DAVIS [continuing]. And then get those markets working in their normal way in that neighborhood. The CHAIRMAN . If you will yield just for a moment, here is a concern that I have. In other words, now that pattern has changed from the normal commercial lenders that Senator Sarbanes is isolating on here, and importantly so. It seems to me in part they are now doing that because, by your efforts, you help take the neighborhood, the area within which you have been operating over the 20-year timer span , you took it up over the redevelopment threshold. 37 You turned the whole area around step by painful step until you finally became, I suspect, an attractive enough area because of the improving dynamics, that suddenly the outside institutions took a different view. They took a look, and they saw that the profile was changing sufficiently that his now-and there may have been some social conscience issues at work, too. I don't profess to know them all. But to the extent it is because you did the hard work to change the dynamics and come up above this redevelopment threshold, are they now coming in because , you know, you have put 20 years into making it attractive to them . My concern is that I would be concerned that if a development bank has to come in and do all the heavy lifting, for some number of years before you finally turn the community dynamics around enough that the commercial bank says "Hmmmmm! Looks sort of interesting." I mean, we have been redlining this area for a long time regardless of the creditworthiness of an individual borrower, but now these folks have plowed the ground. They have turned this thing around. It is now interesting . We will do a little lending in there, too. I am concerned that you may have that element in here that would be part of the story of the 20-year haul that we have to kind of separate out when we think about what is going to happen with the brand new one that is going to start out, and does that new community development bank have to do essentially all of the heavy lifting to get over that redevelopment hump? Mr. DAVIS. I think that is why I think the question that was being discussed earlier today about allowing those banks to invest in community, they ought to be owners of community development institutions. That way, they are locked in from the very beginning. This is an institution where we do not wait 20 years for them to get involved. They are in there from day one as owners, and I would suspect and hope that through that ownership that they would also be investors in the neighborhoods in terms of making loans there. So the time that it took us to get to the point where they felt the market was safe is greatly reduced, because you get them in from the very beginning. Senator SARBANES. Well , the problem that I am worried about is that these community institutions , which I am very much impressed by and in favor of, first of all have-there is a time lag in getting started, but more importantly that they become an in -lieu way of the normal institution responding. In other words, the normal institutions to some extent are engaged in practices that they ought not to be engaged in, that do not have an economic rationale for the practice even on the basis of some of these studies. The question then is : Should they in effect be able to move away, or walk away from that because you put these community banks in their place? I mean , somehow you have to figure out a way to get both, it seems to me, if you are going to try to address this problem. 38 Mr. COMSTOCK. If I could respond to that, I think your point is well taken, in that until there is a large enough amount of investment going on in low-income neighborhoods, then we need everybody that we can get there, by whatever means, to be operating there. We are a long way away from having the community development financial institutions be able to take over the entire role of providing investment in low-income communities. We are just not even close to being there. Senator SARBANES. And we may not even want that. What we really may want is for the normal institutions to recognize the kinds of possibilities that Mr. Davis ' institution recognized and go ahead an take advantage of them. Mr. COMSTOCK . Although in his caseSenator SARBANES. You do not have a separate outfit that manufactures soap to be sold to low-income people. You know, Procter & Gamble makes it and everybody buys it. Mr. COMSTOCK. Although this problem is not common to just banking. I mean, we could talk about grocery stores. I realize you are the Banking committee, so you are not going to focus on grocery storesSenator SARBANES. No. Mr. COMSTOCK [continuing]. But it is not a problem just exclusive to banking in terms of the lack of an economy in a low-income neighborhood. I think Senator SARBANES. Let me ask you this question and then I will desist, Mr. Chairman. To what extent do you think the problem in these neighborhoods has an essential economic rationale to it? And to what extent is it other factors that are at work? That if you really analyze the economics , a good deal could be done a lot of activity could be done on sound economic grounds, but they either do not perceive that, or are unwilling to engage in that kind of activity which is tougher in some ways and therefore they do not go in, and to what extent is it in fact that the economic basis is not there and if you are going to do some of these things you have just got to find unique, underwritten, subsidized ways in which to do them? Mr. LOPEZ. Sir, could I just share this with you? In Grand Rapids, again it depends on the perception of these banks. They look at these communities as a source of raw materials which you can go in and get cheap deposits, and you already redline it. You have a policy of redlining it by not investing in it. You invest that money elsewhere. So it is a good markup. The reaction of some of the banks when we first announced that we had been chartered and that we were capitalizing was to try to snuff us out. They also started pairing off their lending officers , one white, one black, going into the community to ask the people what they wanted. They started out with the ministers. So getting back to the Community Reinvestment Act which seems to be an important aspect of this whole problem of minorities accessing credit is that to be it appears that the banks are satisfied with the concept that they can do public relations and nothing else and get away with it. I think that is what is at the heart of the issue, the way I see it. 39 Mr. DAVIS. Could I try it? I think it would be Senator D'AMATO. Mr. Chairman, if I might, Paul, because you raise the issue that goes really to the heart of it, and to which we have to give careful consideration . If I can make an observation-my proposal is to give banks credit for their investment in the local development banks, or in the banks that are doing the kinds of work that Mr. Comstock's bank is doing, and that Mr. Davis ' bank is doing, that is exactly what I am suggesting. I am not suggesting that we give them a gold star. I am not suggesting to you that they will then be allowed to discriminate. Discrimination is against the law, and we should enforce that law vigorously. If banks are not making mortgages to credit-worthy people, as some of the studies have indicated, we ought to crack down on them. I am suggesting that we have an ability to leverage and bring capital into capital- starved neighborhoods in an intelligent manner and in a way that will in the fullness of time build these community development banks. So what if there are going to be some unprincipled people and there are always going to be some-who say, well, this is the way to meet our obligation, and that is how we will do it. What do we care? If Mr. Davis gets the capital, if Mr. Comstock gets the capital, if Mr. Lopez gets the capital, we have accomplished our purpose. We are not suggesting, however, that banks that capitalize there community development bank can now go out, break the law and discriminate. But it seems to me that in another aspect, and we talked about training and how to get help, that when somebody invests in Mr. Davis' bank, in the Southside Bank, they are helping the community he serves. If they put $ 500,000 worth of capital in there, they are also going to help. They are going to have people in there who are going to provide some expertise, et cetera. It is a natural extension . They have an investment and they are going to see what takes place there, and we are going to begin building bridges. We are going to begin building bridges and getting capital into arteries that do not even exist now. We will first put an artery in there, and we will get that flow of that capital going. Will there be some problems? Sure. But I suggest there will be far fewer than if we do it by using the existing system . Mr. Davis pointed out that for every dollar of capital, that is a $ 15 infusion into the community. So we have a bank that is doing that kind of thing. And there are a lot of smaller banks- not just big banks. There are some small banks, for example-in relative terms they may not be small, they may have $ 1 billion worth of assets -that went to get involved in trying to make loans in depressed neighborhoods and they may not even have any in their community. What a wonderful thing to get them to meet CRA requirements and actually take money from affluent communities and have a stake in investing it in the less affluent communities that are not within their service or market area. I think that potential exists but we have to study it. I do not think it is just a matter of saying 40 that now you can go out and break the law-or not meet basic requirements, that you can go discriminate. I just share that with you. Senator SARBANES. No. I was not suggesting that, obviously. I would assume no one would want to do that. I am trying, though, to get at how these responsibilities are met and how we address the problems that are in these communities, and how we can maximize the effort. A lot of it may depend on what is the price you pay. I mean, if you are going to let them meet their community reinvestment requirements by just sort of buying in, then it is a big question of how much is the buy-in, if you are going to do it that way. Now that still leaves you with the question of whether you want to completely give up on the idea that the normal institutions ought to be that is why I asked this question about the economic differentiation, because if they are cutting it off at a point where the economics still make sense, and my suspicion is that that is the case on the basis of South Shore's experience, that is one thing. If they are cutting it off at the point where they say, look, our bottom line is we have to show a profit and we just cannot handle this particular problem because we are down to a point where the economics of thing just will not work, then that is a different kind of problem. But the question is whether the range in which the economics will work, how you try to address getting the existing normal institutions to assume activity in that range, as opposed to creating institutions which in effect will substitute for them. Mr. DAVIS. Just two responses. I would like to say, I think I have heard nothing here today, and I certainly have not intended in any way to infer, because some questions were asked at the break, nor am I saying that an investment in a development bank lets the banks off the hook. Absolutely not. I think all that I am saying is it is another way to help them meet that CRA requirement. Second, Senator, I think if we had only gone into South Shore with a bank making credit, I would not be sitting here before you today, because we would have lost everything we put in. As I said in my testimony, a development bank is much more than a credit granting facility. I mean, unfortunately in this country-and we all share the blame that we have allowed these areas to deteriorate to a point where perhaps in another day earlier credit would have turned them around. It cannot do it by itself. Senator SARBANES. That is a good point, I think. Mr. DAVIS. So therefore we have got to have a lot of other things going on to make it work. My general rule of thumb is that I would rather lead by example in this area and pull people along rather than try to legislate what they should be doing. Because I think if we can begin to move the banks along to show them that there are profit opportunities in these communities, OK, and work with them, I think that at least the banks we have had experience with in Chicago have indicated an interest in doing that and have in fact begun to participate with us, that we will then get them to the point-which is what I think you are saying- where they will not need us or anybody else. 41 They will view those as good markets and will go off on their own because they have come to feel that they represent good investment opportunities, and that the markets then begin to work in those places. The CHAIRMAN. If I may, and I do not want to be arbitrary in terms of time, and everybody has been very understanding given the interruption for votes, but we have another panel that I want to move to. I do want to make one comment before we leave this panel in thanking all of you for your participation . That is, I do not think we have a lot of time here to work with. We are seeing examples of cities that catch fire and burn down, and we can see a lot more of that happen. Lives and opportunities are being squandered and I think destroyed in effect every day that we under-respond and under-acknowledge a pile-up of problems that has been in our society for a long period of time. So we have got to have a concept that will work, but it cannot take forever and it cannot string out over a long, long period of time because we are playing catch-up as it is. I want to make sure that the extraordinary teams that have come into being that have succeeded , like the two that we are seeing here, and the two that aspire to do it that we have also heard from , I am sure if we could go back and sort of look at the landscape behind us we would find other groups that tried and did not make it. They are not here today because of how relentlessly dif ficult it is to make this kind of thing happen . So I think we have got to harness everybody. We are having discrimination hearings in here within a matter of days because I think I am determined, as Chairman of this committee, that we are not going to tolerate a continuation of discriminatory lending practices by federally chartered and insured institutions. It is not going to happen . The new Comptroller of the Currency has said to my face that he intends to rip it out root and branch, and I intend to rip it out, and I think our new President feels the same way, and I think this committee feels that way. So we are going to unlock that part of the strangled capital that has not been making its way through simply because, as you point out, loans have not been going even where they are economically justified, quite apart from the issue of how you get a community up to the point where it is attractive to new capital investment. We do not have long to do this with, in my view. So we have got to take and compress this timeframe . If it is going to take every community development bank 20 years to get to where you are now, America is not going to beat the train to the crossroad . We have got to do this . We have got to compress this down into a much tighter time frame and thank God we have some relevant experience from which we can draw if we use our brains . We need to do the training and make sure that the credit is coming through, but we are going to need the commercial banking system to step up to the plate and not just cherry-pick the loans that look attractive, or the easy ones. And the regulators are going to have to do their job on community investment criteria. 42 It does not mean a thing to generate a lot of paperwork that does not convert itself to an adequate flow of credit going into the areas that have been starved for credit. I do not want file drawers full of papers so that bureaucrats can , you know, justify the fact that they have been monitoring the problem, when we have got people in communities dying on the vine out there because the credit is not getting through. Maybe we have to set criteria. I do not want some paltry fraction of 1 percent of the capital and the credit making its way into the areas that are dying for lack of credit, and where there is an economic justification for that credit to go. So we have got to do better in that area in the traditional system . We need both . There is no way in the world we are going to get the job done in sufficient volume and in sufficient time unless we get full mileage out of community development banks, which I am for, and I want to grow as many as we can that meet the test of being competent, capable, rooted in the communities and able to succeed, but I want the private banking system and the other financial intermediaries to step up to the plate. I mean, we have got-they have got to respond to the needs of the whole country, and not just a part of it. Thank you, very much. Let me thank this panel. You have been very helpful to us. I will excuse this panel and call our next panel. [Pause . ] The CHAIRMAN. Let me welcome this panel. Again, you have been here all morning, so you know the circumstances of our having been interrupted by the votes on the floor. I know some of you have planes to catch, and we are under very tight time constraints here, in any case. So I am going to make your full presentations a part of the record and ask you to summarize . Ms. Nunez-Morales , I know you must leave soon to catch a plane. Ms. NUNEZ- MORALES. Yes. The CHAIRMAN. I am going to call on you firstMs. NUNEZ- MORALES . Thank you . The CHAIRMAN [continuing]. And if you would each give your summary comments, we will go in that order. STATEMENT OF PAULINE NUNEZ-MORALES, EXECUTIVE DIRECTOR, NEW MEXICO COMMUNITY DEVELOPMENT LOAN FUND, ALBUQUERQUE, NM Ms. NUNEZ-MORALES . Thank you, Mr. Chairman, and members of the Senate Banking Committee. My name is Pauline Nunez-Morales and I am the executive director of the New Mexico Community Development Loan Fund, a statewide organization . Today I am representing my own organization and the National Association of Community Development Loan Funds [ NACDLF ] , an association representing 41 community development loan funds . NACDLF is active in an ad hoc coalition of community development financial institutions which are microloan funds, community development loan funds, community development credit unions , and development banks. This coalition has pioneered the business of community development lending over the past several decades . + 43 We have prepared a position paper comprising our best thinking at this time on the issues involved in setting up a federally supported network of CDFI's . A copy of the paper is attached to my testimony. The CHAIRMAN. We thank you for that. Ms. NUNEZ-MORALES . Thanks. The New Mexico Community Development Loan Fund is a private, nonprofit financial intermediary created in 1989 and dedicated to the economic and social empowerment of the people of our State. The fund borrows capital from 29 socially responsible investors and lends it in support of affordable housing, community based businesses , basic human services, and community development in general. NMCDLF is the only community development lending vehicle in a State that has one of the highest percentages of people living below the poverty level in the United States. As a primarily rural State, New Mexico faces a unique set economic challenges. For many people, major markets are distant. The limited job opportunities, and access to all types of services, particularly financial and public services is inadequate. Over a third of the State's population is Hispanic. Native Americans comprise 10 percent of the population. Both populations make up the majority of rural residents. Within these traditional communities, language and racial barriers can contribute to their inability to access traditional capital sources. The NMCDLF mission is to help create long-term solutions to poverty by placing resources back into communities, to create jobs , retain community services, and improve housing opportunities . To this end, our fund has helped to expand rural health facilities , support organic agriculture, reduce program costs for transitional housing groups , and expand rural enterprises. Let me give you an example of how we work. One of our loans recently was made in Mora County, which is one of the poorest counties in the State of New Mexico. We just recently are going to close on a loan for $25,000 to a logger in that county. It is a small contractor that otherwise would not have been able to have access to capital. We also participate with other institutions in making loans. Last week we closed on an $80,000 loan to a shelter, St. Elizabeth's Shelter, in Santa Fe. That was to help them purchase a nine-unit apartment building to house facilities in transition in Santa Fe. A locally owned bank provided a $ 170,000 loan for permanent financing, and a local donor contributed $50,000 for the downpayment. What our loan helped do was actually make the project happen . So as you can see, the NMCDLF lends for both housing and business projects, recognizing that distressed communities need to develop both aspects of their infrastructures. NMCDLF is a relatively young and small organization in the loan fund industry. The 41 NMCDLF member loan funds have loaned more than $ 100 million which have leveraged $ 760 million in public and private capital to finance 15,000 housing units , and to create 3,500 jobs for poor Americans . NMCDLF strongest member funds, such as the Delaware Valley Community Reinvestment Fund [DVCRF] , in Philadelphia; the 44 Low-Income Housing Fund in San Francisco; the Boston Community Loan Fund; and the Cascadia Revolving Loan Fund in Seattle provide leadership for the NMCDLF and other growing loan funds . They are the pioneers in our field , and their experiences and success are models for growth in our industry. They and other loan funds have demonstrated the nonprofit, nondepository revolving loan funds can aggregate significant amounts of private capital from individuals and institutional social investors, successfully fill gaps in credit markets in urban , rural , and tribal communities, work hand in hand with conventional lenders to their mutual benefit, and finance new forms of ownership such as mobile home park cooperatives and land trusts. These institutions are now planning to significantly increase the scope of their efforts. For example , DVCRF is studying the possibility of adding a depository arm. My colleague from DVCRF, Jeremy Nowack, is here today and would be glad to answer any questions about these plans. And I am afraid he is going to have to handle the Q and A today for me, since I have to leave. At the other end of this growth ladder, new development funds such as NMCDLF are models for emerging loan funds and startup efforts in places like Maine, Western New York, Delaware , South Carolina, and Chicago. NMCDLF believes that a performance based lending and grants program should be the model used to create a national network of community development financial institutions . It fosters discipline in business activities while allowing institutions the flexibility to provide loan products and related services that are appropriate to the communities they serve. Collectively, the existing CDFI industry provides a baseline against which the progress of a Federal program could be measured. Capitalizing more than $ 700 million , much of which was raised from within communities or constituencies they serve-development banks , credit unions , and loan funds-have extended more than $2 billion in loans. Loss rates are comparable to those of the best conventional lending institutions. We offer a solid foundation for a bold community development lending initiative that might include new institutions, community organizations , conventional lenders, and others. We believe that Congress and the Clinton administration must make a clear financial commitment to the CDFI system to signal their support for the long- term viability of the industry. But this should be just one part of the funding mechanism. The $ 850 million figure reportedly under consideration by the administration for dispersement over 5 years seems to be an appropriate scale. We respectfully suggest that this money should be committed primarily as equity support in increasing amounts over the 5 years in accordance with a performance-based lending investment program that provides support to all rungs of the CDFI industry growth ladder. Those CDFI's that perform up to industry standards would gain access to increasingly large amounts of the $850 million . This ensures that the money is not distributed without due accountability measures. 45 That concludes my prepared testimony. Thank you for this opportunity to discuss the work of the New Mexico Community Development Loan Fund and our peers in NACDLF. The CHAIRMAN. Thank you, very much. Ms. NUNEZ-MORALES. As I said before, Jeremy will answer the questions. The CHAIRMAN. Let me excuse you. I know you have got a plane to catch . I want to introduce our final three witnesses, and then I will call on them in this order: Mr. Ron Phillips representing Coastal Enterprises here from Maine; Mr. Robert Jackson representing the Quitman County Federal Credit Union here from Mississippi; and Mr. Michael Swack who is here representing the Institute of Cooperative Community Development from New Hampshire. Let me just say, Mr. Phillips , that George Mitchell, the Majority Leader, had intended to be here and we were not able to be able to tell him when this moment would come, and so he has been on his way at different times and then had to turn back because we were running long. So in any event, he wished to take account of your presence today and to introduce you personally. Having said that, let me invite you now to proceed with your summary, and we will go to the others . I would like to keep these summaries within 5 minutes in each case, if we can do so. Thank you. STATEMENT OF RON PHILLIPS, COASTAL ENTERPRISES, WISCASSET, ME Mr. PHILLIPS. Thank you, Senator Riegle . I was hoping Senator Mitchell would come, because he does such a good job talking about CEI that I could have made my remarks really brief. Senator Riegle and members of the Senate Banking Committee : Thank you for inviting me to testify on the proposed community revitalization system. I am using that term because that is the term developed in a paper written by your staff. My name is Ron Phillips and I am president and principal founder of Coastal Enterprises, a nonprofit community development corporation located in Wiscasset, ME. The community revitalization system is a strategic step to accelerate job-creating community development initiatives. It is an investment in America that will grow businesses , create jobs , building housing, and generate assets for low-income and working families . The return on taxpayer investment will multiply and recycle year in and year out. I encourage your support for and crafting of legislation that is both flexible and inclusive, and that will provide a menu of opportunities for community development banking, credit unions , community development corporations , micro and community loan funds, and small- scale venture capital groups, a network which enthusiastically awaits a resurgence of Federal support for their ef forts. As a practitioner of community development for over 15 years , and board member of the National Congress for Community Economic Development, a 325-member trade association for commu- 46 nity development corporations-and I have attached to the written testimony a list of all the members by State of this association . I want to share briefly with you the legacy of CDC's , CEI accomplishments , and then conclude with some recommendations. What are CDC's? CDC's originated in the 1960's with the title 7 amendment to the Economic Opportunity Act of 1964 to develop businesses, housing, commercial real estate, and create opportunities for disenfranchised residents of America's distressed urban neighborhoods and rural communities. This amendment was introduced in the U.S. Senate by the late Senators Robert Kennedy and Jacob Javits. What we contemplate today for a National Community Revitalization System is owed in great part I believe to the accomplishments of CDC's . CDC's are in virtually all States. Their activities are diverse. They develop and finance day care facilities, community health centers, affordable and supported housing, industrial and business parks , small business incubators and shopping centers. They finance franchises and joint ventures, and provide small- , micro-, and medium - sized loans and venture capital to businesses that cannot secure conventional capital . They are comprehensive and knowledgeable about their communities, create new income and assets for residents , are professionally managed, and leverage funds with the economic mainstream . CDC's are nontraditional financial intermediaries . They work in partnership with the public sector-Federal , State, and local government-and the private sector-foundations , banks, private business-to attract investment and lending capital to low-income communities. According to our recent research studies , between 1985 and 1990 alone over 1,100 CDC's across the United States built or rehabilitated 320,000 units of low-income housing, developed over 17.4 million square feet of commercial and industrial space, made over 3,500 business loans, and created or sustained over 90,000 jobs. Now let me briefly describe CEI as a model rural community development corporation . Maine's is a small business economy with 90 percent of the businesses employing fewer than 20. Yet, Maine has traditionally been at the end of the capital pipeline, ranking among the lowest nationally in bank deposits per capita. It is also among the highest in dependency on transfer payments . CEI was organized in 1977 to address the capital gaps of small businesses to create income, employment, and ownership opportunities for low-income people . CEI is privately and publicly funded. We provide financing and technical assistance in development of job-creating value-added natural resource industries, start-up and expanding small manufacturers , microenterprises, women in business, family and center-based child care , and affordable housing. We link our investments to the hiring of low-income people in our enterprises . We have loaned or invested $ 20 million , leveraged $60 million in partnership with banks, and created or sustained some 3,500 jobs. We are an SBA-504 certified lender and operate the SBA's Micro and the Farmer's Home Loan Demonstration in Maine, Intermediary Lending Program. We participate in private founda- 0 47 tion program related investments such as with the Ford Foundation. What are some examples of CEI projects? We have a growing portfolio financed on the continuum of capital need from less than $5,000 to over $300,000. Our smallest loan is less than $700 to Sweet Deceptions in Lewiston, a self-employed starting AFDC microentrepreneur producer of sugar-free sweets and baked goods with only a very small amount of sales . Our largest is over $400,000 to DeLorme Mapping Co., in Freeport, ME, the home of L.L. Bean, in a subordinated debt loan and an equity investment to a producer of advanced technology geographic and recreational maps, with over 100 employees. The CHAIRMAN. Let me just stop you for a minute, because we are going to run out of time. Mr. PHILLIPS . Yes. The CHAIRMAN. It is very important that we get the recommendations , and I know you are coming to that, but if I may I am going to ask you to jump ahead to that and tell us what you think ought to be done here in light of the earlier conversation that would foster and speed up the kind of work that you are doing. Mr. PHILLIPS . OK. Well, let me do that. CEI's function is to fill the credit gap, basically. We work closely with banks. We work in partnership with them. We have agreements with them both for guarantees, as well as for making subordinated debt loans. Equity and subordinated debt capital is a key feature of our activities. We believe that the concept of a community development bank based on the discussion I have heard this morning is very interesting, and is something we are looking at in Maine. cannot go into too many details about it, but we think in the life of our institution in Maine this could be a very interesting possibility, and it could be perfected in a way that continues our partnership with banks, which is the second level of approach I take. In other words , if you are going to do a piece of legislation here and establish some funds, I would target them in four areas. I have listed them in my testimony. One is of course to set up at least a pilot program for doing some community development banking, and to support further development of credit unions , or at least something to get that niche-bank marketing effort going. The second thing I would do is capitalize existing efforts among CDC's like our organization where we work in partnership with banks . We operate revolving loan funds and equity funds, and we need that kind of infusion of capital from the Federal Government which we can then leverage with the private sector to continue to do our work with banks. The third thing I would do is set up a program to ensure we can get capital that can be used for equity investments . Now the SBA has been the traditional Federal agency in the United States that has been working with an equity type program. It has had some difficulty in the past. There are new initiatives going on there, and it is something that I think we should take a good hard look at as a source of equity capital for venture capital investment. 48 The next thing I would do is make sure that there is adequate grant based funding for microloans and community loan funds because this kind of capital is very difficult to raise in the private sector. Small lending is also very labor intensive. It is costly and capital needs to be very flexible. Let me just try to conclude with this: I would also consider special assistance to nonprofits to form a community development bank or acquire a troubled bank. There may be some opportunities in that area if you can get the FDIC working in tandem with the effort you are making in community development banking. The last thing I recommend is: It is critical to provide technical assistance and planning grants to enable community organizations to analyze their market and develop a business plan . The CHAIRMAN. Thank you, very much. Mr. PHILLIPS . Thank you very much, Mr. Chairman. The CHAIRMAN. I apologize for the time squeeze. We are all in the same time squeeze together here. Mr. Jackson, we would like to hear from you now, please. STATEMENT OF ROBERT JACKSON, TREASURER, QUITMAN COUNTY FEDERAL CREDIT UNION, MARKS, MS Mr. JACKSON. Thank you, Mr. Chairman. I am Robert Jackson , treasurer for the Quitman County Federal Credit Union. We are located in Marks , MS , a low-income rural community in the Mississippi Delta, about 80 miles south of Memphis , TN. I also serve on the board of directors of the National Federation for Community Development Credit Unions , a coalition of credit unions that serve low- and moderate-income communities throughout the United States. The Federation is affiliated with the Credit Union National Association , the national trade organization for credit unions. Speaking for my small credit union and for the larger credit union movement, I would like to express strong support for the new administration's initiative for expanded community development of financial institution activity. The story I have to tell about the situation in the Mississippi Delta will show very clearly just how urgent our needs are. Before talking about the particular experiences of my credit union, I would like to say a few words about the national community development credit union movement. Of the 14,000 or so credit unions in the United States, more than 300 serve low-income communities and rural communities , inner-city neighborhoods , and Indian Reservations. The primary mission of the institution is to provide credit and other financial services to people who are considered unbankable by mainstream financial institutions. The need for credit in these areas is desperate. One CDCU in central Florida makes loans to migrant farm workers who need second hand trucks in order to commute to work in surrounding counties . Another CDCU in San Francisco has made small loans that allow newly arriving Vietnamese immigrants to continue earning a living as fisherman. 49 The Harlem CDCU once lent funds to an entrepreneur who wanted to expand his auto repair business that had been turned down by 10 different banks . In this case, the borrower repaid the credit union loan 3 years early. In Central Appalachia, a CDCU works with public assistance recipients who want to start their own businesses and get off welfare. The groups efforts were recently described in a front page Wall Street Journal article. Hispanic and Haitian immigrant farm workers, Vietnamese immigrants, small business owners in Harlem, and welfare mothers in Appalachia are not the kind of lucrative clients that other institutions are looking to serve. Frankly, in my opinion many institutions do not even want those folks coming in the front door because they cannot make a profit serving that kind of clientele. In Quitman County, our credit union was formed 11 years ago in order to cope with a lack of access to credit. Like many other places in the Mississippi Delta, Quitman County is a place where African-American residents are mired in poverty and trying to cope with the legacy of centuries of economic and political discrimination. My town, Marks, was one of the key cities of civil rights activity that was visited by Dr. Martin Luther King, Jr. , which was highlighted in newspaper publications in the magazine section across the country on Sunday, January 17, 1993. To this day, however, there is persistent rural poverty. Unemployment in the area is 18 to 20 percent in the African-American community, and 9.8 percent overall. The per capita income in the county is $6,450 annually. The per-capital income for African-Americans is lower, $4,133 . Many African-Americans are living in substandard housing without running water. They would like to buy new homes, or repair their old ones, and they would like to start a new business or borrow money to send a child to school. Until 1977 , there was only one bank in the Marks area, and it was owned by a local family that also controlled much of the land and political machinery in the county. Since loans are routinely denied to many poor people, including my parents who were sharecroppers, they did not even bother to go to the local banks. Out of pure desperation, we organized a grass roots movement for equality that led to the creation of the Quitman County Development Credit Union, that is also a CDC and a member of the National Congress for Community Economic Development, and the Quitman County Federal Credit Union . The credit union has $ 1,017,000 in assets and serves 850 members and growing. Since the day we were organized , we have lent more than $2,126,000 to local people, most of whom would not have had other access to credit. To tell you a story about a typical loan that we make to a family that had stayed on the farm, or plantation , all their lives up until 1989, the farmer got sick and could not work on the farm anymore and was asked to move out of the plantation owned house. The family had nowhere to move, no credit history to assume a mortgage, and no breadwinner for the family. The family approached the credit union for a housing loan to purchase a $ 10,000 house. The credit union made the loan because we knew the family. I am 50 happy to say that they have made their monthly payments like clock work. What would have happened to the family? I am afraid to think what may have happened or transpired if the credit union had not been there. This is not an exception; this is the rule. Families are being displaced from large plantations with nowhere to go, no money to move anywhere else , no sympathy from the landowners, no severance pay, nothing. I believe that the CDCU's are financial institutions with a conscience and we need more of them. While we have been successful in providing credit to people who would otherwise be shut out of the capital market, there is a great deal more that we would like to do. We are particularly interested in duplicating the successes of the Nation's largest CDCU, the Self-Help Credit Union of North Carolina. Self-Help has more than $40 million in assets and has extended loans throughout the State of North Carolina. Their success is due in large part to an innovative structure that combines the credit union and a nonprofit development organization. Working together, the two institutions can provide a full spectrum of services needed to further economic development. We have the same structure in Quitman County. Our credit union provides credit and savings services, while the nonprofit Quitman County Development Organization is able to conduct fund raising and take a larger part in high-risk development projects . All this is done in coordination with each other and other nonprofits in the community. I am confident that we can grow to Self-Help's size and scope in a safe and sound manner, but that will require relief from current regulations imposed on us by our regulatory agency, the National Credit Union Administration . We also need more technical assistance from them and a strategic investment of Federal resources . In talking about public investments in CDCU's, an important ratio to keep in mind is 10 to 1. For every dollar that a CDCU receives in reserve funds , the institution is able to extend $ 10 in loans for home acquisitions and repairs , small business development, and other purposes . If credit unions had a $ 100,000 infusion of equity, I can guarantee you that we would make $ 1 million worth of loans in Quitman County, MS, the poorest section of the United States. As you go about the process of creating a community development banking program- and I am confident that you will-there are a few positive steps that you can take to help credit unions like mine and others throughout the United States. I support the recommendations of the National Federation of Community Development Credit Unions for steps which Congress can take to improve access to credit for consumers and small businesses which are in my written testimony. In closing, let me again emphasize the importance to easing the current regulations under which we labor. To effectively do our job, we must never be held back by limits of nonmember deposits , and we must have traditional flexibility in making small business loans to our members . Attached is a CUNA position paper on these issues with amendments, which I support. 51 This concludes my testimony, and I will be glad to answer any questions. The CHAIRMAN. Thank you, very much. That is very helpful, and I appreciate getting that sort of insight with respect to how it is being done through the credit union structure. Mr. Swack, you have been very patient and I appreciate it, and I am going to ask you if you would summarize as much as you can. We would like to hear from you now. STATEMENT OF MICHAEL SWACK, CO-DIRECTOR, INSTITUTE FOR COOPERATIVE COMMUNITY DEVELOPMENT, MANCHESTER, NH Mr. SWACK. OK . Thank you, Mr. Chairman, and committee member. My name is Michael Swack and I am co-director of the Institute for Cooperative Community Development, which runs the working capital program, microenterprise program, that has extended over 450 business loans in the last couple of years. But I also come as someone who has a wide range of experiences with community development financial institutions, having worked in them for 14 years, helped start up two community development loan funds , and I am currently chairman of a community development financial institution that is chartered by the State of New Hampshire. I am here today to speak primarily about microenterprise programs. Microenterprise programs work with entrepreneurial individuals seeking to start or expand small businesses. Microenterprises range from self-employment businesses to businesses employing five people, and typically lend between $250 and $ 10,000 to help a business operate or expand. Microenterprise programs represent a community based economic development strategy for business development and job creation among those traditionally left out of the economic mainstream . They provide individuals with the capital and skills they need to turn their businesses or business ideas into reality. The individuals served by microenterprise programs are predominantly women , often people of color, and almost all are welfare recipients, unemployed, or working poor. The creation of small businesses is just one goal of microenterprise programs. They are also designed to increase income , stabilize families, raise self-esteem and self-confidence, develop skills, create role models and spark a process of community renewal . Over 150 microenterprise development programs are represented nationally by the Association for Enterprise Opportunity in Chicago, which also houses one of the more successful microenterprise programs, the Women's Self-Employment Project . Senator Moseley-Braun , I was told to make sure I mentioned that, if you were here. [Laughter.] Senator MOSELEY-BRAUN. Good. Mr. SWACK. Many microenterprise programs include loan funds , or offer financial services in partnerships with local banks or credit unions, but microenterprises face many barriers . The loan sizes re- 52 quired by microenterprises are typically too small to be considered by traditional financial intermediaries. The cost of transacting such loans is unprofitable for these intermediaries . Additionally , the borrowers are considered to be too risky. They do not have equity to put into the business. They have very little collateral, and they do not have histories of running profitable businesses. Although these loans are considered too risky by traditional intermediaries , many community based organizations have successfully loaned to microenterprises. My own organization , the Institute for Cooperative Community Development, has run a program called Working Capital, for the past 2 years. We have made close to 450 loans utilizing a model of lending called peer lending, a model utilized extensively overseas in places like Bangladesh and throughout Latin America. In this model, people join borrowing groups . Members start out by borrowing small amounts of money for their businesses, and incrementally are able to borrow more. We have enjoyed close to a 97 percent repayment rate over the life of the program . In addition to providing capital, many microenterprise programs provide training, technical assistance , and in some cases support services such as child care and transportation to borrowers. The provision of these nonfee-generating services combined with the small loan sizes means that microenterprise programs are typically not able to support themselves on fee and interest income alone. Although it is not within the purview of this committee, it is important to note that microenterprise programs face barriers other than the barrier of access to capital. For microenterprise programs to succeed, the Government must eliminate barriers and penalties for transfer payments and public assistance recipients who pursue self-employment. They are currently penalized. We need to allow AFDC recipients to accumulate business assets and deduct business related expenses in calculating that income. We need to change unemployment insurance laws to exempt recipients from looking for work while they are starting a business , and we need to change public housing rent provisions to minimize increases for residents generating wage or self- employment income. Any legislative initiative to create community development financial institutions we believe needs to explicitly recognize and encourage microenterprise lending, whether through microenterprise loan funds or other community based intermediaries . An investment of Federal funds into microenterprise funds could be done in a variety of ways. Our Working Capital Program has worked out a unique arrangement with three different banks in New England whereby we have access to bank lines of credit for microenterprise lending. In exchange for access to this credit, we establish small loan loss reserves at the bank. A small investment into loan loss reserves currently made by foundations has enabled us to leverage substantial amounts of credit from banks for microenterprises. A legislative initiative that supports investment in microenterprise funds in training and technical assistance to borrowers we be- 53 lieve could greatly enhance the viability and success of these programs. Finally, as someone who has been an active participant in community investment for 14 years with a variety of institutions , I have four specific recommendations that do not apply only to microenterprise, and many of them were touched on this morning: First, a wide range of community development financial institutions, including community development banks, credit unions, loan funds, and microenterprise funds should be eligible to receive investment from a Federal initiative for community development financial institutions. However, any institution receiving investment from a Federal initiative should specify how they will help achieve goals of community development and investment . Community investment means more than simply investing money in a particular geographic place. A successful program of community investment has succeeded in many places in creating those community organizations which then go out and build housing and create jobs. We have found with the New Hampshire Community Loan Fund, of which I am a founder, that our simple existence has created many community organizations that never would have existed because they now know they can access credit. They have gone out and built housing and developed jobs . A key in community development finance, and you have heard this quite a bit, but this is a slight variation on it, is the need for equity investment. A Federal initiative should provide equity or permanent capital to community development institutions, but also allow them to invest equity in community housing and economic development ventures. Traditional loan products are simply not sufficient to meet community capital needs. My experience as chairman of the New Hampshire Community Development Finance Authority, a quasipublic agency, has demonstrated how critical equity is to the success of projects. Through equity investments-and we do not actually own these businesses ; we do it through preferred shares, or getting a share of net operating income-we are able to invest the kind of money that then leverages private money. There is not a single deal that we have been involved in-and in the past year we have made about $3.5 million worth of equity investments, that would have gone ahead if we were not able to put equity into the project. Allowing community development financial institutions to invest equity is a way of getting greater participation of private financial institutions. Equity investment improves the capital structure of the venture. It leverages private debt. And most importantly, it enhances the probability of financial success of the venture itself. The CDFA also encourages-and in fact is completely funded through private investment. I think it is something worth looking into in response to a question Senator D'Amato asked . The State of New Hampshire provides a tax credit against a business's business-profit tax to commit funds to this General Venture Fund. The CDFA then uses these funds to make equity and debt investments into community based housing and economic de- 54 velopment projects . That is, the legislation specifically directs that it must go into community based housing and economic development projects . Federal legislation should include mechanisms that encourage private sector investment into community development financial institutions. Finally, the Federal initiative, we believe, must promote the development of secondary market mechanisms to support the growth and liquidity of community development financial institutions. One of the things that we have really had problems with is, we have made these loans , but since they are non-standard underwriting criteria, we are often unable to place these loans. So we have demands on our money. I know we could make a lot more loans. We often come to the table where we say, well , we are having requests for about $ 1 million of loans. We have only $200,000 we can make right now. If we are able to package these nonstandard ones that we seasoned, that we can provide credit enhancements for, to either institutions like existing banks or through Government Sponsored Entities like Ginnie Mae and Freddie Mac, I believe that would greatly enhance our ability to increase the flow of capital to these communities. Finally, I believe that we do have the expertise here that has been mentioned several times. It is not just the South Shore Bank. There is a lot of expertise . There are probably 500 institutions represented by the various groups here that are involved in this . That experience has been gained over the 15 years . We have a track record that we invite you to look at in terms of loan losses and money placed that we think compares favorably to any traditional financial intermediary. So in the focus this morning and concern on South Shore Bank, it is important to expand that to say that, although it is still a fairly narrow level of expertise, it goes far beyond one institution. Thank you for allowing me to speak. The CHAIRMAN. Well, I appreciate that. I appreciate your point, and that is why we have asked you to be here, to both make that point and to draw on that level of knowledge and differentiation . I am going to submit to you some questions that I will have on behalf of the committee and on behalf of other committee members to respond to for the record . I am going to give the gavel here to Senator Moseley- Braun for her questions, and she will take you on through the remainder of our hearing today. I want to thank you for your participation, and again thank you for your patience. It is frustrating for all of us when we set our time schedule and events over which we have no control intervene , but that is the nature of your life much of the time, and it is the nature of our life here all the time. So, Senator Moseley-Braun . Senator MOSELEY- BRAUN [ presiding]. Thank you, very much . Mr. Swack, I have a question with regard specifically to the microloan funds and the enterprise development that you were testifying about. One of the distinguishing characteristics about the South Shore experience was that it integrated the banking and financial services with technical development and, if you will, human 55 resources development, and helped people get around to navigate other kinds of issues that were not purely financial or credit related. To what extent you mentioned in your testimony the need for welfare reform , to recognize this as an area, and public housing authorities, to recognize this to what extent do you provide technical assistance, human resource development assistance to people as a part of the loan strategy, or the community development strategy? Mr. SWACK. There is a wide variation among microenterprise programs. In some of the programs it is very, very extensive. That is, the human development element is in fact one of the most, if not the most important element, and the way success is measured in these programs often is not simply has a person gone on and created a job. That is, if you have gone through a training program in business development, some people may start a business, but if you go back and you say has the program been successful a couple of years later, you may say, well, what if the person does not have a business that employs him full time? But what if instead they found permanent employment in the work force? Is that not also a successful outcome? So there are different ways that microenterprise programs measure them. Certainly for many microenterprise programs the training component in business development, developing cash-flow statements , identifying a potential market, writing a business plan, getting access to capital , are key in terms of the success of the business owners themselves. Senator MOSELEY-BRAUN . Again I guess the question- and that is part of what I wanted to hear you say to me this afternoon, but I guess the second part of the question is: To what extent do you help people after the loans are made to continue to do what it is they have to do? I mean , a lot of time it is a lack of accounting experience or expertise. A lot of time people just do not know what the rules are and what the expectations are. Mr. SWACK. Let me talk about our Working Capital Program in particular. Working Capital requires people to stay in peer groups after they get the loan. That is, we do not forget about them afterwards . And in fact, one of the elements of the model is technical assistance , rather than being loaded all up front, what we will typically do is go through a very short training period with the borrower, get them a small amount of credit-everybody starts with $ 500 quickly-and begin to identify the different technical assistance needs that can be provided to those groups on an ongoing basis . There is learning on the job while they are starting their businesses. The peer groups are the agent through which we are able to provide a lot of technical assistance , and we work through community groups , community enterprise agents throughout the region. That is, we have a central program that only employs a couple of people. Then we contract with community groups to organize these peer groups. The enterprise agents are also responsible for coordination of technical assistance that we can provide. 56 It is very important that it is on an ongoing basis both through the peer group assistance they give each other, as well as assistance we offer in how to do marketing, how to set up books , how to get to the next level . So it is an ongoing process of technical assistance provision . Senator MOSELEY-BRAUN . Mr. Phillips . Mr. PHILLIPS. Yes. May I respond to that? We help a lot in that area. About a third of our effort at Coastal Enterprises is in technical assistance both before a loan and after a loan, and in fact, also in other than lending relationships. We operate a counseling program and have three full-time business counselors that have counselled some 4,000 businesses over the past 5 or 6 years. So it is a very, very active program, and they have also facilitated those small businesses-which average about 2.5 people in employment to get bank loans not just loans from our flexible revolving loan fund. They have managed to facilitate some $ 10 million of financing just through the technical relationship of working with clients on all those issues you are talking about, from clinics and workshops, taxes, accounting, to one-on-one counseling, marketing, and so forth. A second area, which is a very exciting area and is what the group in Chicago does, too- and I hope you will visit them sometime is a very specialized, customized program to help AFDC recipients gain access to self-employment. They participate in a much more intensive and even peer support type of training program. We are working with about 170 in a 3year program in rural communities and some small urban communities in Maine to deal with the opportunities of transitioning AFDC recipients from welfare to work through the self-employment process. Participants go through a very rigid business planning type of development, understanding how to put a plan together, very small step loans , and working alongside our loan staff as well as counselors to then break into a more independent business of activity. So it is a very, very busy area for us , and for a lot of our peers throughout the country. Senator MOSELEY- BRAUN. What has been your experience with that effort? Do you receive State and local support for that? Mr. PHILLIPS. We have a special Federal grant. It is money given to us to create a pool of capital to support both the technical assistance side, as well as the softer loan side of the equation. Senator MOSELEY- BRAUN. A Federal grant from where? Mr. PHILLIPS. From the Department of Health and Human Services, Office of Community Services. Senator MOSELEY- BRAUN. And State and local? Mr. PHILLIPS. The State Department of Human Services - we have a $ 1 billion budget deficit, by the way, in Maine. Senator MOSELEY- BRAUN . One billion dollars? Mr. PHILLIPS. A $ 1 billion . It is a very difficult time there. So they are struggling, but they are putting some money into the program . They also complement the program with various supports to the participants in child care , transportation, and that sort of thing. 57 We have a nonfinancial agreement with them, basically. We have to have an agreement with them to work in tandem with this program. It is a very interesting relationship and it is one that we need to keep encouraging both at the Federal level , which actually requires it, but as well at the local level. Yes? Senator MOSELEY-BRAUN . I am sorry, Mr. Phillips? Your State has a $ 1 billion deficit, not Coastal Enterprises? [Laughter. ] Mr. PHILLIPS. We are actually quite solvent. Senator MOSELEY-BRAUN. OK. I was just trying to help out there. Mr. PHILLIPS. No, we have a healthy fund balance. Senator MOSELEY-BRAUN. So the State Department of— Mr. PHILLIPS. Human Services. Senator MOSELEY-BRAUN [continuing]. Human Services is also involvedMr. PHILLIPS . Yes, as a partner. Senator MOSELEY- BRAUN. Is there other local participation? Mr. PHILLIPS. There is an employment training program in the area that handles the Department of Labor funds. Senator MOSELEY- BRAUN. I hope I am not asking redundant questions now. I think everybody knows I had to goMr. PHILLIPS. I mean, all these programs work in coalitions and partnerships. The name of the game is partnership . Everybody does a piece, and maybe we will get something done. Senator MOSELEY-BRAUN. Now what is your public-private funding mix? Mr. PHILLIPS . We have about a third of our funds from private foundations. Largely the balance, maybe shy of 10 percent, from the Federal Government. The State government has put some money in. Senator MOSELEY- BRAUN. OK, so the bulk is Federal, some State, a tenth of the Federal of the two-thirds public money and a third private. Mr. PHILLIPS. Basically, yes. Senator MOSELEY-BRAUN. And in terms of your loan experience, what has been your experience? Mr. PHILLIPS. That is the anchor of our program. We do financing, technical assistance, and development work. We have done 300 business projects over the past 8 or so years . We have put out $20 million of our money. The key thing here is we have leveraged another $60 million of primarily bank financing. That is our partnership with the banks. So in effect we are bringing them into the kinds of projects and sectors that are vital to Maine economic development, from the very small microenterprises, to some very important other sectors. We have done a lot of child care development in Maine, both small family day care loans as well as larger facilities , such as Head Start/Child Care wrap-around facilities. We just participated in a Head Start Project in Rockland, ME which was about $380,000. We also had the bank as part of that, and the Farmer's Home. We also raised private money locally . So it is a real party. Senator MOSELEY-BRAUN. To what extent and this will be my last question to what extent have you been able to establish con- 58 tinuing relationships or communication with the major, large financial institutions in the community? And if you have established that, in what form does it take? Do you have regular meetings with them? How did you get their attention? Mr. PHILLIPS. I am glad you asked that, because I think that is vital to our work. We cannot work without the banks . No. 1 , we are co-lenders. We work in a subordinated debt relationship . No. 2, we have three bankers on our board, Fleet Bank, Key Bank, and Casco Bank, which is owned by the Bank of Boston. We have a network with banks, and have deposits with banks, and link our projects and relationships with them. We also get money from them. They donate money to us particularly for our technical assistance programs because we are basically helping to make projects bankable, and there are new prospects, new borrowers for them. Also some of the banks have been working on very direct TA programs and mentoring type programs, and we have given them some advice on how to internally develop better ways to interact with their markets . So they are a vital part of our operation. Does that answer your question? Senator MOSELEY- BRAUN. But how do you interface with them? Mr. PHILLIPS. Well , I had an example of a company we financed in Westbrook, ME, which is Moulded Fibre. It takes recycled paper and processes it into a fiber product that can be molded to any particular shape. It replaces styrofoam as a packaging material. Senator Gore visited that company before the election , and he was using that as an example of a job creating environmental company. That was a $ 1 million start-up project. They hired AFDC people, and people with disabilities. They employ about 44 now. We got the bank involved-it happened to be Fleet Bank, with a percentage of the financing. We had to provide the equity and subordinated debt financing to make that happen . So in financing a project, we bring the bank in and we provide the more flexible subordinated capital. Am I answering your question? Senator MOSELEY - BRAUN. Maybe I am not asking the question right. Your relationships with the majority banks, is it just a matter of informal relationships? Or is there something more structured, something more formal, something that is institutionalized that allows you to have regular interactions with the majority banks? Mr. PHILLIPS . Well , a lot of things happen in rural communities more informally than formally as a network, and one way of expressing oneself institutionally is the informal network. We do have standing agreements, written , signed agreements , however, with seven banks that reflect the fact that we are going to deposit money in the bank, say up to $ 100,000 , and in turn the bank will both interact with us by way of referring projects , or work with us on financing a project that it may not be able to do on its own. We still have to review the business , but the relationship triggers that process. Those funds can also serve to guarantee a portion of the bank loan . So that is a more formal part of that. Senator MOSELEY- BRAUN . Thank you . 59 Mr. Nowack. STATEMENT OF JEREMY NOWACK Mr. NOWACK. Just to build on that, many of our relationships with banks, or relationships where the banks invest in us directly, but in the last few years we have structured a formal participation pool with banks where banks buy into participation pools in areas that we manage where they commit a certain amount of money based on some agreed upon underwriting criteria that we work out together. We process the loans and put the loans on, and then we monitor and service the loans. So we become a wholesaler for those banks . That has happened particularly-and it has happened with the largest banks in the Philadelphia region . It has happened particularly in parts of north Philadelphia and Camden where they have been most resistant to credit provision. So banks have seen us as kind of a wholesaling arm for them, and we have seen in the banks a form of credit, obviously. But we have bought also with our own loan fund, our own $ 10 million loan fund, we have bought 10 percent of each one of those credits for the banks . Senator MOSELEY- BRAUN . Would you send to us something in writing on that situation? Mr. NOWACK. Absolutely. And if I could just say one very brief word, so much of the conversation earlier today was around this almost either/or issue of CRA and banks . I think that most of our experience is that you cannot look at it as an either/or question . The way that you build community development financial institutions in part is by getting banks to meet CRA regulatory requirements. And a significant way to meet CRA regulatory requirements, but not the only way to meet CRA regulatory requirements , is to work with institutions like ours, and I think that is an important point. Senator MOSELEY-BRAUN. I think one of the things we are looking at is to the extent that we can make CRA more of a carrot and stick than it is currently. Mr. NOWACK. Right. Senator MOSELEY-BRAUN . And so everybody is really groping for directions and answers in that regard, and I think it will be on a bipartisan basis . So we really appreciate your contribution to helping us find some answers in that area. I want to thank all of you : Mr. Jackson , Mr. Phillips, Mr. Swack, and Mr. Nowack, for your testimony. The vote bell has already rung, so the members have to go off and vote. As you know, I am now standing in for Mr. Riegle, but I want to thank you for your contributions to this hearing to this important area. I am confident that the chairman will follow up and will continue in this area, and we are certainly open to any further submissions that you might have, or information , or assistance that you can give the committee. So, ladies and gentlemen , thank you very much. This meeting is recessed to the Call of the Chair. 70-832 0 - 93 - 3 60 [Whereupon, at 2:05 p.m. , the committee was recessed , subject to the Call of the Chair.] [ Prepared statements and additional material supplied for the record follow:] 61 PREPARED STATEMENT OF SENATOR RICHARD H. BRYAN Mr. Chairman, I commend you for holding this hearing today to provide an overview of community development banks and to familiarize the Committee with the operations of the four existing community development banks. As we know, President Clinton has proposed a network of community development banks as part of his urban policy, this hearing will give us all an opportunity to become acquainted with this private sector initiative. Many of our urban and rural areas are severely distressed with a multitude of problems : homelessness, crime, unemployment, and hopelessness. These are the many faces of decline. We must not allow our cities and towns to languish, we must address these needs and find ways to revitalize our communities. However, we are hampered in our efforts by our growing deficit and the decreased ability of the Federal Government to finance new programs. The success of these community development banks shows that solutions do exist using private sector capital with some incentives from the Federal Government. The availability of capital in these communities means the residents will have the possibility of establishing new businesses, building affordable housing, and putting resources back in the neighborhoods- in other words creating jobs. I am anxious to hear from our witnesses today about how they have achieved their great success and their suggestions about how the Federal Government can help make this network of community development banks a reality. PREPARED STATEMENT OF SENATOR CAROL MOSELEY-BRAUN Mr. Chairman, the subject before us this morning is extremely important to lowand moderate-income communities around my State and across the Nation. Community development banking must be a real priority for this committee . I therefore want to congratulate you, Mr. Chairman, for calling this hearing so promptly. At the outset, I want to take special note of one of our witnesses. Milton Davis of the South Shore Bank is a constituent of mine. He is a banker who has really made a difference to his community. You don't have to do anything more than walk up and down the streets in the neighborhoods where South Shore lends to see the dramatic difference he and his institution have made. We in Illinois are very proud of South Shore Bank. It is a bank with a national reputation, and it is a reputation that is fully deserved. There are a lot of questions regarding community development banking that must be addressed. Today's witnesses, however, by their very presence, point out an important policy objective for any community development banking proposal this committee considers. That is, it must be flexible; it must permit multiple approaches to community development that takes local community needs carefully into account. We need institutions that can make loans, use loans to leverage additional financing from more traditional financial institutions, make equity investments when that is called for, make micro-loans that can make such a difference to individuals and their neighborhoods, and undertake the full range of community development financial needs. Not every institution can or should necessarily do all of these things, but any Federal approach must allow the kind of institutional flexibility that permits communities to move forward with approaches that meet their own special needs. I look forward to hearing from all of the witnesses here today. They bring a variety of experiences to bear on community development issues. They can tell us about a variety of approaches that have worked in communities across this Nation. I know their testimony will be of great help to us as we work with the administration to meet community development needs . PREPARED STATEMENT OF SENATOR GEORGE J. MITCHELL Mr. Chairman, I'm pleased to be here today to introduce Ron Phillips, the founder and President of Coastal Enterprises Inc. (CEI), a non- profit community development corporation based in Wiscasset, Maine. Coastal Enterprises has been a leader in small business lending in my State and has mobilized over $60 million to support a variety of manufacturing, child care, natural resource, and microenterprise development projects in Maine. CEI specifically targets assistance to low-income people, women, and people with disabilities. As an original cosponsor of the Micro Lending Demonstration Act, I have worked closely with CEI on issues related to small business credit. I can affirm that under Ron's leadership, CEI has established a strong record of achievement in bringing financial and technical resources to Maine businesses through partnerships with banks, public and private agencies and community organizations. 62 I commend Ron for his dedication to this program, and I applaud him for all he has accomplished for the people of my State. He is a recognized leader in the field of community development corporation lending, and I'm sure that based on his extensive experience he will bring valuable insights to the hearing you are holding today. I congratulate you, Mr. Chairman, for holding this hearing. So many communities, both urban and rural, are desperately in need of credit and investment policies that will stimulate growth and create new jobs. President Clinton drew attention to the need to create a network of community development banks to encourage investment and opportunity in distressed areas. I hope the hearing you are holding today on development initiatives will focus attention on the diverse network of community-based lenders that already exist. Development banks have made a tremendous contribution to their communities, but I am sure they would be the first to admit that they are not alone in their mission. Many other community-based organizations, like CDC's, perform the same functions and pursue the same goals as development banks. They may work cooperatively with development banks, as well as conventional banks, to achieve their purpose: To provide financing that is vital to stimulating economic growth in disinvested communities. I believe a wide array of community based lenders, and CDC's in particular, should be integral part of any strategies or programs implemented to rebuild our troubled communities. As you examine the issues related to invigorating community development lending in our country, please look at and learn from what already successfully exists, as well as what we can build for the future. Thank you for the opportunity to introduce Ron Phillips, and I assure you I look forward to working with you , Mr. Chairman, and the rest of the committee on developing these initiatives. TESTIMONY OF MILTON O. DAVIS, CHAIRMAN, SOUTH SHORE BANK OF CHICAGO FEBRUARY 3, 1993 Honorable Chairman and Members of the Committee: Thank you for inviting me to make recommendations about the creation ofcommunity development banking institutions . I assume that it symbolizes a marked national increase in interest in institutions that can react effectively to investment opportunities in the Nation's troubled urban neighborhoods and small towns. The invitation requested information about the history, structure, experience, impact and lessons of the bank holding company that my colleagues and I founded on the south side of Chicago in 1973. I have been asked by a sister institution, Southern Development Bancorporation in Arkansas, to convey its experience as a development bank holding company which serves small towns in rural southern Arkansas. Finally, Shorebank and Southern would like to offer some principles that could guide Federal assistance to the creation of such institutions in other places. Shorebank is a comprehensive community development institution: the "need" it aspires to address is development of disinvested communities, but not exclusively credit needs. Indeed, a salient lesson of our experience is that community development requires more than credit, and delivering credit successfully requires more than a bank. For this reason, it may be most helpful to understand Shorebank by focusing first on the concept of community development banking and the resulting institutional prerequisites. Within this context, I will describe the experience and lessons of Shorebank and Southern to date. I. RENEWING COMMUNITY ECONOMIES : The Concept of Development BankinG The failure of the local economy-particularly of its markets and market driven investments-ranks high among the many causes of decline in urban communities. In deteriorating communities, capital flows out of the area; people cease upgrading their homes and landlords fail to maintain their buildings; property values fall; store owners quit investing in their businesses and close or move; community residents lose hope, stop investing effort in education and work skills, and fall into unemployment. In declining small towns, patterns are similar and , in addition, residents rely more on absentee -owned large corporations than locally owned small firms for employment and entrepreneurial opportunities due to weaker links between residents and business markets and financing. Revitalizing such communities requires recognition that disinvestment is itself a market phenomenon and, consequently, will only be reversed by fundamentally reinvigorating local markets. Per- 2 63 manent, self-sustaining community renewal results from creating an environment where private investors inside and outside the community are confident their investments will be rewarded as healthy community dynamics are restored. A few key observations concerning this process of community renewal and investment underlie the concept of development banking: • Many persons in economically distressed communities desire to improve their own life conditions and, although they may lack conventional credit histories, many ordinary residents are fundamentally credit-worthy. Local residents will invest time and money to improve their community when they are confident about its future. • Local development capacity, be it in the form of "ma-pa" entrepreneurial rehabbers, fledgling business entrepreneurs, or community development corporations, needs to be supported in a disciplined, business-like fashion. Positive community development is a long term partnership between residents who care about their communities and financial institutions with similar motivations. • Market forces can be restored in under-invested communities if the level of institutional capability is sufficient for the task at hand, and if redevelopment is targeted to clearly identified geographical areas with the potential for renewal. Targeting allows an institution to develop the necessary specialized market expertise, and assures that investment will be concentrated in order to create the critical mass of activity which shifts resident and investor perceptions and reestablishes healthy functioning markets. • By using an array of banking, real estate, venture capital, technical assistance, human resource and other tools tailored to particular community needs, a community development banking institution enhances its market knowledge and impact, controls risk, and undertakes complementary activities which create a positive, safer environment for private investment. Sustained economic development occurs when local residents invest their savings and talent. The clearest indicator of a permanent community renewal process is active investment by private and institutional investors who believe that an identity exists between their self-interest and that of the current residents. Deliberately accelerating local economic activity requires releasing this local energy by providing access to capital, credit, technical assistance and market information; and by supporting an entrepreneurial culture that values risk-taking, business discipline and self-reliance. In particularly distressed, disinvested communities, external resources must be attracted to leverage the limited local capacity and allow provision of the necessary credit and capital. Ultimately, development banking seeks to restore healthy market forces by attracting and combining the resources necessary to building a critical mass of permanent development activities sufficient to restore investor confidence in the community. Institutional Implications: Characteristics ofa Community Development Bank. The term "community development banking" means different things to different people in the community development finance field. My colleagues and I believe that a community development bank is a bank holding company with a specialized structure which is organized to transform the market dynamics of a geographical target area. This structure, including a bank and community development subsidiaries, has a number of attributes which make it particularly well suited to promote the revitalization of distressed communities. • As a fully regulated, large scale institution, a bank is known, trusted, legitimate, well-capitalized and self-sustaining. • A bank possesses unusual capacity to be continuously knowledgeable about the neighborhood economy. • A bank can convert ordinary bank deposits into development loans. This availability of credit committed to the community can precipitate the release of local energies, inducing residents to risk their own savings and become personal stakeholders in the future of their community. A bank alone, however, cannot accomplish these objectives in the context of distressed communities with dysfunctional markets. A community development bank is designed to be a comprehensive community development institution which, in addition to a bank, includes other development subsidiaries and affiliates that complement the investment activities of the bank. These subsidiaries and affiliates enable a development bank to successfully manage what would otherwise be higher risk investments; to more aggressively identify and better evaluate opportunities and initiate development activities; and to address multiple dimensions of community renewal, ranging from developing retail shopping centers to upgrading labor 64 force skills. Through its non-bank development affiliates, the institution can invest equity capital in businesses owned by others, rehabilitate and construct residential and commercial real estate, operate social development and business technical assistance programs, attract other private and public investors, and generally link residents, financial resources and government programs into a coherent renewal effort. A community development bank is further distinguished from conventional banks by its specialized commitment to the revitalization of a targeted area for the benefit of current residents. Through its leadership, ownership and governance structure, the development bank makes its mission the long-term development of a community. It measures its success in terms of the development impacts it has on that community. It becomes a permanent institution whose success is joined with the improvement of the community. In order to accomplish its mission, the development bank's leadership and staff must bring together highly localized knowledge of the community, technical banking skills, and a broad understanding of the strategies and process of economic development. Thus, a development bank combines the structure and expertise of a for-profit financial institution with the commitment to place one normally sees in communitybased non-profit organizations. By developing specialized expertise in carefully targeted areas, and achieving synergies through comprehensive coordinated interventions, a development bank is able to manage the tensions between the goals of profitability and community development impact, making development profitable. Profitability is an essential feature of a development bank. Profits enable the bank to be self-sustaining and to grow and assure that continuing business discipline will be brought to the task. However, while profitability is essential, the purpose of a development bank is not to maximize profits, but to help effect lasting community renewal. A development bank also combines the qualities of a community based, market driven, private institution with unusual scale, expertise and ability to leverage resources. A development bank is a uniquely capable delivery agent for external public and private resources. Many private and government programs are not fully available in the communities for which they are intended because of the lack of sophisticated, market based delivery systems. A development bank uses foundation investments and grants, Federal loan guarantees, secondary markets, low-income housing tax credits, JTPA and numerous other programs to accomplish common objectives. A development bank can be considered a “handyman" of sorts, intimately familiar with particular local problems, equipped with a "toolbox" of varied government and private "tools" to address them, and possessing the expertise to select and productively use the appropriate tool. Finally, a development bank can be flexible and innovative. Location dictates strategy and design: the organizational structure and the strategies or tools it employs can be adapted to a wide range of circumstances. Thus, whether a bank or other kind of large scale, regulated depository institution is most appropriate, and what affiliated activities are needed, will vary from community to community. For example, Southern Development Bancorporation uses a different array of affiliates than Shorebank as it has been designed to specialize in business and rural development rather than urban community reinvestment. (See organizational chart.) II. SHOREBANK CORPORATION : HISTORY, STRUCTURE, AND IMPACT The South Shore community where I reside was 100 percent white in 1960 and 70 percent black in 1970. By 1972, little credit was being extended in the community despite excellent housing and amenities; the neighborhood is on Lake Michigan and a 15 minute drive from downtown. South Shore Bank, its largest bank, assumed that the inevitable economic decline that accompanies racial change would occur in its market and sought regulatory permission to move downtown. During the late 1960's, an interracial group of bankers-Jim Retcher, Ron Grzywinski, Mary Houghton, and myself-had begun a successful minority small business loan program at the nearby Hyde Park Bank and Trust Company in the University of Chicago neighborhood. The program out-performed similar large bank programs, according to a Yale Law Review article at the time. We began exploring the potential of additional private sector approaches to urban problems, including a carefully structured bank holding company as a vehicle for reversing the downward spiral of deterioration that accompanied racial change. In 1972, The Federal Reserve Board stated that bank holding companies: "possess a unique combination offinancial and managerial resources making them particularly suited for a meaningful and substantial role in remedying our social ills.” 65 Fed regulations under the Bank Holding Company Act explicitly permit bank holding companies to make equity and debt investments in corporations or projects designed primarily to promote community welfare. Backed by patient, primarily institutional, investors who shared our community development goals, we formed the Illinois Neighborhood Development Corporation (now called Shorebank Corporation) to be a one-bank holding company and in 1973 purchased the South Shore Bank. In 1978, we raised additional capital to create two additional for-profit subsidiaries and one nonprofit affiliate. This was the first attempt to use a banking enterprise as the core of a comprehensive development institution for revitalizing an economically distressed, inner-city neighborhood. The Corporation's principal subsidiary, The South Shore Bank of Chicago, is a commercial bank chartered by the State of Illinois and regulated by the Federal Deposit Insurance Corporation. The other subsidiaries and affiliate active in its targeted communities in Chicago include: City Lands Corporation (CLC): a for-profit real estate development company engaged in multi-family housing and commercial real estate development. • The Neighborhood Fund (TNF): a for-profit venture capital company licensed by the U.S. Small Business Administration as a MESBIC . • The Neighborhood Institute (TNI): a 501(c)( 3) non-profit community development corporation engaged in labor force development (job training, job placement, educational remediation, self-employment support), cooperative, rental and ownership low-income housing development, cultural and civic activities. The Bank and these three affiliates operate in concert in targeted communities in Chicago. (In 1986, Shorebank targeted a second community-Austin, on the west side of Chicago-opening a branch of the bank and focusing CLC, TNI and TNF activities there. Austin also has good housing stock and locational advantages, but has suffered from 20 years of disinvestment . ) The non-bank affiliates can take greater initiatives than the bank. They take the first steps to change the market. Thus, for example, the real estate subsidiary will initiate large scale, visible and attractive housing-rehabilitation projects requiring more complex development and financing, generally including several layers of public subsidy. The dozens of local, entrepreneurial real estate borrowers which the bank has cultivated can then follow wide multiple smaller scale private rehabilitations in the same area, knowing that these investments reinforce each other's viability. Similarly, Shorebank's real estate subsidiary developed a major shopping center, attracted a major grocery anchor tenant and leases space to minority owned businesses supported by the venture fund and/or bank; our non-profit affiliate placed several hundred residents in jobs created by the anchor tenant. After twenty years, including a difficult start-up period and the challenging learning curve of a new type of institution, Shorebank has achieved considerable success. Through December 31 , 1992 , ¹ Shorebank has made development investments totaling $ 351 million in its targeted Chicago neighborhoods. In 1992 alone, over $41 million was invested in Chicago development loans and other projects. As a result of its efforts, through the end of 1991 , Shorebank had financed or leveraged the renovation of some 7,716 residential rental units in South Shore alone, almost 30 percent of all such units in the community. In both South Shore and Austin , local black rehabbers are transforming the neighborhood, building by building. About 100 rental buildings, with 6-36 units, are improved each year. Charts reflecting annual and cumulative development achievement are attached. Not shown in the attachments are the non-financial community development achievements: for example, TNI manages three small business incubators; and, in 1991 , TNI placed 380 residents in private sector jobs. Equally important, Shorebank has been financially successful. The bank performs at levels comparable to its peer group banks, and the holding company has been profitable in every year since 1983. As of December 31 , 1992, Shorebank assets had reached $244 million and stockholders' equity stood at $ 17 million; South Shore Bank assets were $229.1 million, with equity of $ 14.2 million. 1992 bank net income was $2.2 million, constituting a 15.3 percent return on equity and a 1 percent return on assets. For the last ten years, the compounded annual growth rate in the book value of common shares of the holding company has been 16.6 percent . Substantial additional detail is provided in the attached charts. In the last five years, Shorebank added three additional subsidiaries and affiliates to manage expansion activities. They are Shorebank Advisory Services, a for-profit consulting firm providing comprehensive advisory services on community economic development; North Coast BIDCO, a for-profit small business investment company regulated by the State of Michigan; and NEICorp . , a 501 (c )( 3) non-profit organiza¹1992 numbers are estimated; final numbers are not yet available. 66 tion which supports small business development in the Upper Peninsula of Michigan. A current organizational chart for Shorebank is attached. Southern Development Bancorporation in Arkansas was formed with Shorebank assistance in 1988. It targets small towns in southern Arkansas from offices in Arkadelphia and Pine Bluff. Its mission is to channel appropriate financial and information services to local entrepreneurs so that small town residents can build thriving, diversified economies and be independent of the decision-making processes of large, distant corporate headquarters (who previously moved low value-added branch plants in and out of their towns). In 1992, Southern invested $9 million, bringing cumulative investment to $19 million (for 74 firms, 27 farms, 79 self-employed residents, and seven real estate projects). In addition, Shorebank assisted in structuring the recapitalization of the Douglass Bank, a minority-owned bank in Kansas City, Kansas, and continues to assist it through a five year advisory contract. Finally, through the Polish American Enterprise Fund, Shorebank helped create and run a small business loan program in Poland. Shorebank Advisory Services is currently working with about a dozen credible organizations from throughout the country which are in varying stages of seriously exploring establishment of development banks, and presumably there are many others. In every instance, particular local needs and capacities dictate an adaptation of the institutional design. The general principles-that a flexible, private, marketdriven bank holding company committed to community development as a business, intimately familiar with targeted local markets and achieving synergies through reinforcing affiliated non-bank activities, can contribute to restoring community economies-appear to be applicable elsewhere. Shorebank's own experience in Arkansas and Michigan supports this. Nevertheless, development banks are only one model, are neither necessary nor appropriate in many communities, and are far from a panacea. Other existing models and programs, often complementary or addressing other equally important markets and needs, similarly deserve support. Such programs include community development loan funds, community credit unions, micro-lending programs, and community development corporations. Policy and Legislative Implications The expanding and welcome-discussions concerning community development banking involve institutions engaged in a wide range of activities, from conventional banks to community development corporations. As these discussions turn to legislative activity, it will be crucial to be clear about the distinct goals and markets addressed and the most appropriate mechanisms for addressing them. The goals of community development and of expanding access to credit are complementary but distinct. In the particular market niche of disinvested, local communities, a development bank appears to be a successful model for promoting community development because of its ability to both successfully provide credit and proactively engage in the additional initiatives that are required in order to succeed. I urge you to devise ways to support the capital needs of various institutional structures with distinctly different programs. This will avoid the risk of a broad, shallow program which will accomplish little. Supporting an array of different types of institutions under one umbrella will result in programs that do not work well for any because the legislative support is not sufficiently tailored to their particular strengths and weaknesses. If one carefully analyzes the differences between the types of institutions, the credit products they offer and the markets they serve, it becomes clear that reducing these issues to a least common denominator of "community lending" is counter-productive. "Community lending" encompasses a lot of different activities and institutions, all of which are important and should be supported, but which need to be supported in different ways . The distinct categories where government opportunities are presented are: 1. Legislative and regulatory incentives directed at existing commercial banks to achieve an increase in community lending and community development . 2. A program to facilitate start-up and expansion of community development banks. 3. Strengthening the array of programmatic support available to any entities engaged in community development. Existing Commercial Banks. There are 11,000 commercial banks in the country, government regulated and funded in part by government insured deposits. The response to inner-city deterioration and rural stagnation could be led by the existing commercial banking system. The key Federal policy action is to use the regulatory process to offer major financial incentives in exchange for quantified and significant levels of investment in low- and moderate-income communities. Banks do not invest 67 much in these communities today. Distressed economies need smaller loans, a local presence, more sophisticated lenders, and partnerships with comprehensive redevelopment efforts. These realities reduce profits; this is a legitimate disincentive for privately capitalized banks. Yet the country's 11,000 banks employ seasoned loan underwriting talent, have proven credit mechanisms and controls, and know how to operate within a prudent and regulated context. They have not yet been sufficiently motivated to apply this talent to the specials business of economic development banking. Legislative action defines the permissible activities of these regulated depositories . Permitted activities could be orchestrated to better serve public purposes by allowing those depositories which are most responsive to public needs to also engage in profit making activities that are now prohibited or curtailed. Interstate banking privileges, authorization to sell insurance, permission to underwrite securities, higher levels of deposit insurance, or other incentives could be provided to banks engaged in public purpose lending. Such privileges, however, should only be granted to banks that meet a high hurdle of investment in low- and moderate- income communities. Clarification of the Community Reinvestment Act, particularly its enforcement system, such that it rewarded proportionately higher investment levels in lowand moderate-income communities, rather than tolerating resources spent in documentation and process, could also further these goals. In the highly regulated banking industry, the tightening of regulations and regulatory enforcement can have a significant effect on the availability of credit . The tension between maintaining the regulatory oversight necessary to ensure the safety and soundness of each institution and the industry as a whole and ensuring banks the latitude to exercise the independent judgment necessary to meet credit needs is a delicate balance. Small business lending, in particular, has recently been negatively effected by a change in this balance . New mechanisms must be found to encourage lenders to prudently but aggressively make more loans to small businesses. Credit enhancements, such as mechanisms to securitize small business loans, need to be developed. Finally, some large banks might most productively invest in low- and moderateincome communities indirectly through a business partnership with a community development financial institution. Such partnerships might include investments in community development organizations that include community development banks , community loan funds, community development credit unions and micro-credit programs. These types of partnerships should be taken into consideration in the incentive structure. Community Development Banks. Conventional banks and community development banks do not compete; they are natural partners. Community development banks operate in a market niche which is generally not "bankable" except by such specialized, comprehensive institutions . In effect, they "grow" the market for conventional banking much more than they take a " slice" of the existing " pie." The need for a network of development banks would not be supplanted by expanded community lending by conventional banks, but rather development banks would reduce risk for conventional banks. A few preliminary thoughts on the proposal for Federal support for expanding the number of community development banks follow. Creation of a network of 100 community development banks over the next four years can have a dramatic impact on the quality of life in disadvantaged communities across the country. In scope, this plan is very ambitious for the allotted time. However, the creation of a large network of development banks can be achieved if legislation is enacted during 1993 that provides Federal funding for equity investments in development banks. Community development banks need to continue as privately-owned, regulated, financial institutions subject to the discipline of the marketplace and the oversight of economically self-interested investors . Equity investments by the Federal Government should, therefore, be matched by equity investments from the private sector on at least a 1 to 1 basis. Investments by Federal Government should be made and overseen by an independent agency ("Entity") that will carefully select and nurture these nascent organizations . The ultimate success of this program will, however, depend upon the extent to which local market forces rather than regulation set the direction of development banks. Development banks will fulfill their mission by responding to the marketplace, not a command and control bureaucracy. Development banks need capital . They must also generate profits to support future growth and generate financial returns for their shareholders-including the Federal Government. If the Federal Government is serious about creating a national network of development banks , it must invest equity capital in these banks and expect a long term financial return on its investment . The Entity that manages this investment activity should be independent of existing regulatory authorities and 68 apolitical. The mission, structure and management capacities of each development bank will vary with the need of the distinct geographic area it serves. Thus, a careful, competitive, selection process must be implemented which selects institutions with comprehensive business plans, well-qualified professional management, an experienced board or directors, appropriate structures tailored to the needs of local communities, and demonstrated capacity for comprehensive community development An array of institutional structures will be appropriate to particular circumstances, including partnerships with existing community development corporations and financial institutions. Accordingly, the Entity must be afforded great discretion in its investment decisions. Grants, forgivable loans, and other creative financing should be made available to support start-up, and to support the work of the non-bank, non-profit affiliates of development banks on the cutting edge of development finance. The non-bank affiliates of existing development banks focus on human development issues and on making "non-bankable" deals work. The non-bank affiliates will be the arena in which community development banks interface most with traditional financial institutions in areas such as low income housing development, equity financing for small business, workforce development, and technical assistance for entrepreneurs. Viable affiliate organizations working in partnership with the financial subsidiary, delivering non-bank development resources, are essential to the success of the development bank . As a federally insured depository institution, a development bank will be highly restricted by existing regulatory authorities. As noted above, this regulation provides a level of discipline and credibility which is crucial to success. Development banks emphatically should not be established under a wholly new, special charter which exempts them from the existing regulatory system. At the same time, additional Federal regulation, specific to these institutions, would unnecessarily stifle them. The Entity should exercise guidance particular to development banks through the avenues available to it as a principal shareholder. First, the selection process must be rigorous. Only organizations that card leverage Federal investments with private capital and demonstrate capacity to manage a regulated depository as part of implementing a carefully designed, comprehensive community development program should be considered for investment. Secondly, the Entity can guide the course of development banks by being an active shareholder, voicing its concerns and voting its shares. Finally, the Entity can exercise control through investment agreements that identify specific goals for each development bank. Investment agreements would allow the Entity to replace management or to withdraw from a development bank in the event that the bank does not make sufficient progress in fulfilling its development (as opposed to financial) goals. On a regular basis, the Entity itself should be required to report to Congress on the development impact and the financial return on its investments in community development banks. In under-invested communities, development banks are net importers of the capital needed to stimulate local markets. This happens in two ways: through equity investments by private owners and through deposits generated outside the community. Development banks must attract these funds in the same manner and at essentially the same investment terms as conventional banks. However, development banks are at a competitive disadvantage in competing in the national marketplace because they are smaller and have higher costs associated with their support for development activities . Equity investment in development banks must be made with the expectation of the ability to recoup one's investment with a modest return. If investors do not have this expectation, the discipline and oversight critical to success is lessened. On the other hand, achieving community development goals is a long term undertaking that requires patient investors that do not seek to maximize profits. Innovative mechanisms to enhance the long term financial viability of equity investments in development banks and to increase the liquidity of such investments would increase the availability of private capital and lessen the need for Federal equity investment. Similarly, conventional banks, particularly those that do not have retail lending operations, could be significant partners with development banks. These institutions do not have readily available, effective delivery mechanisms for meeting local credit needs in under-invested communities. Equity investments in community development banks could expand their ability to meet their responsibilities under the Community Reinvestment Act without the requirement that they change the nature of their business . Sanctioning and encouraging these types of investments could provide a new source of capital for development banks. Recognition of the public purpose served by banks making equity investments in development banks should not 69 replace continued emphasis on CRA enforcement and serious attention to the need to remedy racial disparities in lending markets. The majority of depositors in development banks seek market rate, FDIC- insured bank deposit products. Because development banks draw from a national market place, non-interest bearing checking accounts are not an attractive product because of the slowness of making deposits by mail. Allowing ATM deposits across state lines in development banks would make regular checking accounts more attractive to a national customer base. Many potential social investors, like pension fund, nonprofit institutions, and religious endowments, would deposit in development banks if deposit products could be developed that meet their needs as fiduciaries to secure the highest return with the lowest level of risk. An increase in the amount of FDIC insurance available to development bank depositors would leverage more deposits without additional cost to the Federal Government. The deposit base of a development bank, like that of a conventional bank, needs to be diverse to guard against sudden outflows from a small number of depositors. Individuals interested in a social return on their banking might be more able to deposit in development banks if the deposit products were fully competitive with those of large conventional banks. However, development banks are not large enough to have the economies of scale needed to offer these products at competitive rates to large numbers of individuals. Creation of innovative tax deductions or credits for foregone interest on below market rate deposits would open access to deposits from individuals and corporations without jeopardizing the income stream of the development bank. Numerous other issues need to be considered for legislation to foster large scale replication of development banks . Appropriate training and capacity building programs will be needed, particularly to build from the strong existing base of community financial institutions. Development banks can achieve public purposes on a profitable basis, through unusual institutional design and partnerships. The challenges of inventing an appropriate Federal role and of assuring careful implementation are considerable but, I believe, well worth the effort. Programmatic Support for Community Development. This third category of potential government activity encompasses a universe of existing and new programs . Particular, distinct programs could be broadly examined, enhanced, coordinated and made available as appropriate to all institutions-from conventional banks to microloans funds which engage in community lending. Guarantee mechanisms (such as those of SBA and FHA), secondary market mechanisms (such as FNMA and FHLB), housing tax credits, JTPA funds, loans to revolving loan funds from the Department of Agriculture, capital grants from HHS, and other programs are all essential “tools” of community development. Performance based programming tailored to the distinct types of institutions, products and markets should be expanded. A great deal of additional attention might be productively devoted to this category. Others much more qualified that I , including many who are attending this hearing, might be asked for suggestions. Thank you. 70 Southern Development Bancorporation Bank Holding Company Elk Horn Bank and Trust Opportunity Lands Corporation SBA Guaranteed Loans Agricultural Credit Working Capital Real Estate Development: Commercial Space and Low Income Housing Arkansas Enterprise Group 501 (c)3. Tax Exempt Non-Profit Organization Southern Ventures, Inc. Good Faith Fund Equity Capital, Small Business Investment Corporation (SBIC) Small Loans and Services for Sell-Employment Development Finance Management Consulting Market & Sales Development Working Capital, Equipment Leases. Short Term Loans Manufacturing Accounting Consulting, Bookkeeping. Training Market Research, Sales Brokering, Network Development AEG Manufacturing Services (AMS) O 50 100 150 200 250 1988 Deposits Assets oans l Ꮕ 1987 millions $ Shore Bank South 1989 1990 1991 wth Gro n Loa and sit D , epo et Ass 1992 Est . : 1/25/93 30120003.n08 71 250 500 750 1000 1250 1500 1750 2000 1987 TNI CLC Units Housing 2:1992 activity 1991 exceed to Expected TNI -Austin CLC -Austin 1988 SSB 1989 Woodlawn Chatham -G,Arehab South or uburn resham -f':Multi in amily SSB O -' ther SS A- ust B in 1990 Shorebank Corporation 1991 1992 Est.2 Neighborhoods Minority in Chicago Housing Rehabilitated Corporation Shorebank A Area ,bffiliate & y Rehabbed Units Housing 21220 n08 1/6/9 3005 |: 72 12 50 100 150 74 75 976 977 78 19 19 1 1 19 200 250 300 350 400 millions in 19 79 0 8 9 1 81 19 82 19 83 19 84 19 Netghborho the od Institute Lands City Corporation South Shore Bank 85 19 Shopor reb ank Cor ati on 19 86 87 19 88 89 90 19 19 19 92 19. st E 351mm Shoreban Corporati k Cumulativ on Results : e Over $ Million 3 00 Communit in Developm y ent Investmen Since 1974 t Dev Invest elo men pme tnt 12122 0007.n08 1/6/93 |: Cum ula Ann e ualtiv New Chi cag o 73 16 61 South Shore Bank City Lands Corp. Chicago Operations The Neighborhood Fund The Neighborhood Institute Shorebank Advisory Services S () AS Shorebank Corporation North Coast Bidco NEIC orp . Upper Peninsula Shorebank Corporation Organization Chart 2122000 |:1/6/93 1.n08 74 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 1987 m$illions 1988 Shore South Bank 1989 1990 ROAA -O 1991 T - ax Pre Income 1992 Est . 0.00 % % 0.25 % 0.50 % 0.75 % 1.00 1.25 % % 1.50 % 1.75 Pre T Incom - ax e and Retur n Avera on ge Assets : 1/25/93 30120001.n08 75 0.25 0.00 0.75 0.50 1.25 1.00 1.75 1.50 2.25 2.00 R OOAA NI 1987 m$illions 1988 Bank Shore South 1989 1990 1991 1992 .Est 0.00 % % 0.25 % 0.50 % 0.75 % 1.00 % 1.25 % 1.50 Net Incom e and Return on Avera Asset ge s 1212200 02.n08 1/6/93 |: 76 0.00 0.25 0.50 0.75 1.00 1.25 1.50 figures unavailable Group Peer 21992 1985 0.42 8.91 1986 00 129 Reports Performance Bank DIC :FPGroup Uniform figures 'eer 1987 0.42 077 outstanding loans of Percent South Bank Shore 1988 10.08 0.78 1989 10.12 0.87 1990 0 04 46 2 1991 0.67 1992 Est.2 0. 0.44 40 ' Group Peer South Shore 20 Bank Y ears 8 Last Group o 7 in f its Peer Better than Near or Performs Shore Bank South Net Group Peer to Compared Losses Loan 121220004.n08 :1/6/93 77 0.00 0.25 1988 1989 1990 1991 1992⚫ .Est ending :For months nine 9/30/92 0.00 % 2.50 % 5.00 % 0.50 % 7.50 10.00 % 12.50 % % 15.50 % 17.50 0.75 1987 FOF ROE NI 1.00 1.25 1.50 1.75 2.00 millions $ Shopor reb ank Cor ati on Net Incom and Returne Equity on 30120002.n08 : 1/25/93 78 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 NL R Ꮕ OAA 1987 m$illions 1988 1989 1990 Shoreb ank Corpor ation 1991 1992 Est . 0.00 % % 0.25 % 0.50 % 0.75 1.00 % 1.25 % 1.50 % Net Incom Retur and e on n Avera Asset ge s 21220003.n08 ;|1/6/93 79 $ O 500 1000 1500 2000 2500 3000 3500 eleven *:For months ending 11/92 b %etween 16.6 of rate .1983 1992 and Sh or eb an Corp kn or at io Share Equivalent 1983 1984 1988 1986 1990 1985 1989 1991 1987 1992⚫ .Est Shoreba achieve nk c a ompoun d annual d growth 30120004.n08 1/25/93 : Book Value Per Common and Common 80 81 STATEMENT OF LYNDON COMSTOCK CHAIRMAN, COMMUNITY CAPITAL BANK FEBRUARY 3, 1993 1. Personal Statement Thank you for inviting me to address the Committee on the topic of community development banking. My name is Lyndon Comstock. I am the Chairman and Founder of Community Capital Bank of New York City. Community Capital Bank is, as far as I know, the only independent commercial bank ever organized in the U.S. specifically as a community development bank. Our bank is now 2 years old and has $20 million in assets. I am also the Chairman of LEAP, Inc. LEAP is a nonprofit venture development organization with its office at Community Capital Bank. LEAP provides intensive management assistance, including help in sourcing risk capital, to small businesses in low income areas. 2. Community Development Financial Institutions At the outset, I'd like to note that community development banks are only one of the categories of community development financial institutions, or CDFI's. I include as CDFI's, along with community development banks, community development credit unions, community development loan funds, microenterprise funds , and venture development organizations . While there are only three independent commercial banks that explicitly specialize in community development lending, there are a total of more than 300 CDFI's at present. I recommend that any Federal support encompass all of the various categories of CDFI's, inclusive of the rural and reservation -based CDFI's, as well as the urban. Assisting in the expansion of existing institutions, and not just the creation of new CDFI's, is particularly important. Our bank is a member of a recently formed ad hoc coalition of community development financial institutions, which advocates Federal support for building the capacity of the CDFI industry. Í understand that you have been provided with a copy of the coalition's position paper, "Principles of Community Development Lending and Proposals for Key Federal Support." Each type of CDFI has done a highly effective job of supporting community development, especially so considering our limited resources. We are professionally managed, private sector organizations that have been created and operate with little or no Government assistance. The capacity of each type of CDFI could be significantly increased, however, with appropriate Federal support. 3. Need for Community Development Lending The largest pool of investment capital in the U.S., and the most important to the financing of businesses, housing, and consumer credit, is the several trillion dollars within the banking system. What proportion of total bank lending goes to low- and moderate-income individuals, their housing, or the businesses in their communities? I estimate no more than 1 percent. Yet more than half of the people of our country have low- or moderate-income. Half of the population, yet perhaps as little as 1 percent of the bank loans. This situation could be fairly called "capital starvation" for the low- and moderate-income communities which suffer from it." CDFI's represent a useful starting point for increasing our Nation's investment in the development of low- and moderate-income communities . CDFI's make virtually all of their loans in low- and moderate-areas, yet, as an industry, have had little problem with loan losses to date. CDFI's have proven their ability to provide the critical first wave of investment and project development in economically devastated neighborhoods, and to do so for the benefit of the existing residents, not their displacement. And CDFI's do this work at their own choosing, without regulatory pressure and elaborate negotiations . 4. Expanding the Capacity of CDFT's As part of an overall national strategy of dramatically increasing investment in low- and moderate-income communities, I urge the Federal Government to help promote a major expansion in the capacity of the CDFI industry by the end of the century. There are three principal factors needed to make a major expansion of the CDFI industry possible. First is equity capital. Hundreds of millions of dollars in equity capital will be needed by the CDFI industry over the coming years to make possible the degree of expansion of CDFI's which the Clinton administration has called for. Because the capital markets for social investment capital are only beginning to take 82 shape, a high level of Government participation will be needed to help induce adequate private sector investment. Second, a large amount of technical assistance is needed in order to help create the needed flow of new community development projects. High quality technical assistance is critical to the success of new community development projects, yet it is inherently unlikely to be self-funding. Additionally, technical assistance is needed for new or emerging CDFI's. Third, professional training programs will need to be created to help provide the staffing for a major expansion of the CDFI industry. Conventional financial experience is an excellent starting point, but I believe ČDFI loan officers and technical assistance providers need a specific background in community development-related projects. Since "community development financial institution" isn't a term defined by statute or regulation, minimum eligibility requirements need to be established for any Federal CDFI support program. I suggest two key criteria. The applicant institution should have an explicit, formally adopted, primary mission of supporting community economic development, which ought to be appropriately evidenced. Further, the CDFI's loans or investments must be principally directed to the support of community development once the Federal support has been utilized. I suggest that be defined as: at least two-thirds of the loans or investments of the CDFI must support affordable housing, small businesses , or social services in low- or moderate-income areas, or provide credit to individuals of low- or moderate-income . It should be the CDFI's responsibility to make an affirmative showing that its lending or investment practices meet this definition if it wishes to receive Federal support. New CDFI's, whether startups or conversions of existing institutions to CDFI status, will not have had the opportunity to prove their community development orientation, Those new CDFI's should therefore be required to submit a detailed business plan which supports this intended lending or investment posture. 5. Community Reinvestment Act Within the context of this discussion of CDFI's, I have two comments I'd like to make about the Community Reinvestment Act. First, I believe that all of my colleagues in the CDFI industry agree that any Federal support for CDFI's should not cause any weakening of the CRA. We support full CRA enforcement. Also, it's entirely unrealistic, in my opinion, to think that the CRA will cause widespread bank support for CDFI's, which could therefore substitute for Federal support. Banks already generally receive CRA credit for investing in CDFI's, but have only chosen to do so in relatively small amounts . Most of that investment has been deposits or their equivalent, rather than the equity investment and technical assistance grants which are needed for the expansion of the CDFI industry. I hope there will be more investment in CDFI's by banks, but Federal support is needed if there is to be any significant step-up in the rate of CDFI formation and expansion. 6. Community Capital Bank Turning to the CDFI's that I've founded, Community Capital Bank is a New York State chartered, FDIC insured commercial bank . Our Bank has made or committed more than $7 million in loans and letters of credit so far, all of which are community development related . Approximately $3 million of this total is directed to multiunit affordable housing, while the other $4 million supports small businesses and nonprofits in low- and moderate -income areas of New York City. Examples of these small business loans include minority contractors , nursing homes for AIDS victims, and a Ben and Jerry's franchise in Harlem employing homeless men. I'm happy to tell you that Community Capital Bank does not have a single nonperforming or delinquent loan so far. Community Capital Bank was initially capitalized at $6 million, which we raised from socially concerned institutional and individual investors in a limited public offering. Approximately one-third of our capital is from a wide variety of religious organizations, one-third is from other institutions including banks, corporations, foundations and labor unions , and one -third is from 190 individuals . I know from personal experience that raising this amount and type of capital for a new organization is extremely difficult. In our case, it took about one person -year of professional staff time per million dollars raised , not to mention the help of numerous unpaid supporters . The problem of raising equity capital is the single most important reason that there are so few community development banks today. Community Capital Bank has received no Government subsidies of any type to date. We've received a $ 100,000 CD at a market rate from the New York City Comptroller's office, but the rest of our $ 15 million in deposits comes from some 800 pri- 83 vate institutions and individuals. We do make active use of Government credit enhancement programs, especially the SBA loan guarantee program. Because our bank is unsubsidized and needs to support itself financially, we must operate efficiently. We are running an entire $20 million bank with eight people, about to increase to ten. Our people are talented professionals, and all except our secretary have previous banking experience. Our President and CEO, Stephen Laine, has almost 30 years in banking. Our V.P. Real Estate, Gina Bolden, has an extensive background in affordable housing lending. Since our loans are entirely commercial loans requiring individual crafting, they are quite labor intensive. We have been able to compensate for this by being extremely efficient on the operations and deposit gathering sides of the bank. Much of our deposit support comes from socially concerned investors, which has allowed us to construct a stable deposit portfolio efficiently and at reasonable cost. 7. Competition Our bank makes small commercial loans-from $25,000 up to $450,000, or to $750,000 with an SBA guarantee. Let me sum up for you the competition in that market in lower income areas of New York City. We have had only two deals where we were truly in competition with another bank. We haven't lost any of our existing loans to another bank. And we haven't taken a loan from another bank that was anxious to keep that loan. 8. LEAP, Inc. I would also like to briefly describe LEAP, Inc. to you. LEAP started out of a recognition that a commercial bank can't provide risk capital, meaning equity or seed capital. A bank also has significant problems providing intensive technical assistance, partly for legal reasons. LEAP is a nonprofit which fulfills these needs for small businesses that have a high community development potential, especially as to job creation. I refer to LEAP and similar organizations as venture development organizations. LEAP does not have its own pool of capital. Instead, we use our knowledge of foundations and other socially concerned investors to help access capital for these small businesses. LEAP focuses on two particular industries at present-food processing and primary health care. Our current clients include an effort by a group of laid-off bakery workers to start their own employee-owned commercial bakery. Another client is a group of Caribbean-American doctors who hope to start a Medicaid managed care program in central Brooklyn. Because we receive so many requests for information about community development banking, LEAP has also become involved in providing technical support to some other community development banking efforts. 9. Federal Government Support I hope that your investigation of community development financial institutions will lead you to the same conclusion I reached some years ago: CDFI's are a highly effective, private sector means for channeling capital into community development . Federal Government support could greatly boost the capacity of the existing CDFI infrastructure. This support should target both existing CDFI's, to enable them to increase their scope of activity, and the creation of new CDFI's. A relatively small amount of Government support for the expansion of this industry could ultimately have a dramatic effect on community development, especially because of the inherent leverage of equity capital by CDFT's. To give you a feel for the dollars needed, a new community development bank should aim for $5 million to $8 million in initial equity capital . This will enable the bank to reach approximately $40 million to $60 million in total assets within a few years . If Federal equity investment were provided on a 1 :2 match, the Federal investment would therefore be $2 million to $3 million per bank. For other types of CDFI's, the initial investment per institution will usually be significantly less. The creation of fifteen or twenty de novo (startup) community development banks over the next few years would be a major accomplishment, and could be achieved with appropriate Federal support. In this context, I'd like to note that seed capital is very difficult to obtain for startup CDFI's. The cost of organizing a new bank can be estimated as up to 15 percent of the initial capitalization. For a $6 million capital bank, this leads to an estimate of as much as $900,000 in organizing costs. Federal grants for half this amount could greatly accelerate the formation of new community development banks and other CDFI's. The incentive of Federal equity capital could help lead some existing banks to become community development banks, which would also expand the network of 84 CDFI's. And the existing network of CDFI's could significantly expand its asset base with the benefit from Federal equity investment of some tens of millions of dollars, again utilizing a 1:2 match. Any Federal equity investments must be nonvoting. In the case of community development banks, I recommend twenty-five year preferred stock investments with a noncumulative dividend in the 2 percent-3 percent range. In that case, it will be important that Congress provide a directive to banking regulators that these investments be counted as the equivalent of perpetual preferred stock (Tier 1 ) core capital until the final five years of their term. For the remaining term, I suggest the investments should be considered the equivalent of intermediate-term preferred stock (Tier 2) supplementary capital . All community development financial institutions, new or previously existing, which receive Federal equity investment should be required to provide annual compliance information as to their support for community development until that investment has been retired. Immediate repayment of the equity investment should be required for noncompliance. 10. Technical Assistance to New CDFI's Specialized technical assistance for new and emerging CDFI's is needed. For example, for each new community development bank to attempt to duplicate the learning process needed for a successful equity underwriting effort, including knowledge of the national network of social investors, is impossibly laborious. Yet there are no investment banking firms at present which assist in this type of socially directed underwriting for CDFI's. The organizing process for a CDFI, especially a community development bank is complex, difficult, and not widely understood. I refer now not just to the regulatory approvals needed, although that is certainly a significant part of the bank organizing process, but to the actual creation of a substantially sized and, in some CDFI categories, highly regulated business . Appropriate business planning, board member recruitment, and management recruitment are the most critical issues, along with regulatory approval and capital raising. A highly particular type of technical assistance, rooted in both the finance and the community development issues of a CDFI, is needed to help launch new CDFI's . Federal support to assist with the organizing process for new CDFI's could best be provided by grants or contracts to help pay for the cost of appropriate technical assistance from specialized providers. The availability of the qualified management needed for an expanding number of CDFI's is likely to be problematic for the foreseeable future. For example, with community development banks, it will be a prerequisite to recruit experienced bank officers for the more senior positions, presumably from community sized banks where they will have had exposure to the types of issues and breadth of responsibilities faced by management of a small bank. In my opinion, the pool of senior officers of small banks who will have both the capacity to succeed in managing a bank focused on low-income communities, and the desire to take such a job, will be rather limited. The only obvious answer to this problem is to train more bank officers who combine the experience and qualifications to manage a bank with the skills and interest to manage a bank that is specifically focused on community development. That, however, could become a very long-term project if the process isn't actively assisted. 11. Legislation Finally, it's important that any legislation supporting CDFI's be flexibly structured. This is a young and growing industry, whose needs are evolving. A responsive administrator of Federal support is equally important, so that the process doesn't become so time-consuming as to be effectively useless, especially for newly forming CDFI's. I urge that strong input from CDFI practitioners be incorporated into the administration of any Federal support to CDFI's . The best vehicle for accomplishing these administrative purposes may well be a quasi-independent corporation . I appreciate the opportunity you've given me to express my views on community development banking. I will provide you with one page summary descriptions of Community Capital Bank and LEAP, Inc. are attached for your review. Thank you . COMMUNITY CAPITAL BANK-SUMMARY DESCRIPTION Status • New York State chartered, FDIC insured commercial bank . • Two years old. • Third commercial bank in the U.S. with an explicit community development focus. 85 • First de novo community development commercial bank. • All loans to date support multi-unit affordable housing, small businesses, or nonprofits in low- and moderate-income neighborhoods of New York City. • Full assortment of deposit products at market rates, plus CIRRUS ATM cards, FEDWIRE, and ACH. Financials $20 million in assets at 12/31/92. $7 million in loans and letters of credit committed, all community developmentrelated, to 30 borrowers. • No delinquent or nonperforming loans so far. • $ 15 million in deposits from 800 depositors in 25 states. • 60 percent of deposits from institutions, 40 percent from individuals. $2 million assets/employee exceeds industry average for operating efficiency. Capitalization • $6 million initial equity capital from 250 shareholders. One-third of capital from 30 religious organizations. One-third of capital from 30 corporations, banks, foundations, and labor unions • One-third of capital from 190 individuals . Loans • All commercial loans to date. Loans for working capital, construction, permanent mortgage, and equipment , plus standby letters of credit. • Examples of borrowers including nursing homes for AIDS patients, housing rehab in Brooklyn, minority contractors, minority owned Ben & Jerry's franchise, knitwear manufacturer, small apartment buildings, and hardware stores. • Government credit enhancement programs are used, especially SBA loan guarantees. Staff • Eight employees, increasing to ten in early 1993. • All employees but one have previous banking experience. • President and CEO Stephen Laine has almost 30 years of experience in small banks. • Chairman Lyndon Comstock (part-time) has both community development and banking background. He is also Chairman of LEAP, Inc. , a nonprofit venture development organization with its office at Community Capital Bank. Mission The purpose of LEAP, Inc. is to help businesses that benefit low- and moderateincome communities in New York City. LEAP is particularly interested in assisting businesses that provide decent jobs for residents of these communities . LEAP is known as a community development venture sponsorship organization . Services To support the creation or expansion of for-profit or nonprofit ventures, LEAP provides a range of services chat combine elements of investment banking, venture capital raising, and management consulting. LEAP assists management in: • Raising capital-e.g. grants, equity, senior and subordinated debt-for a variety of purposes including seed capital, working capital, and funding of fixed assets. • Key development tasks-e.g. management recruitment, business planning, test marketing, site selection, and access to professional services. • Strengthening finance, marketing, and public relations, including use of specialized consultants or peer contacts. Clients LEAP's current clients are food production and primary health care companies as well as microenterprise funds. LEAP works intensively with a small group of clients over an extended time frame. Client selection is not based on ability to pay. Staff Lyndon Comstock, Chairman . Jonathan Glazer, Project Director . Vivian Hunt, Project Director. Earl DePass, Project Associate. Brenda Lauchart, Secretary. Board of Directors Lyndon Comstock, Chairman, Community Capital Bank/LEAP Inc. Beverly Brown, Program staffs Joyce Mertz-Gilmore Foundation. Carl Ferenbach, General Partner, Berkshire Partners. John Guffey, Chairman , Calvert Social Investment 86 Foundation. Oliver Wesson, President, Morgan Community Development Corporation. LEAP's office is located within the office of Community Capital Bank in downtown Brooklyn. LEAP is a tax-exempt nonprofit corporation under IRS section 501(c) ( 3). STEVE W. LOPEZ, PRESIDENT/CEO, THE FUND TO ORGANIZE THE SOUTHSIDE BANK WHY THE NEED EXISTS IN DISTRESSED NEIGHBORHOODS TO IMPROVE ACCESS TO CREDIT Although African Americans, Hispanics, etc. comprise a substantial segment of inner-city residents in the United States, they continue to live outside the beltway of the capitalistic system: To participate fully in the capitalistic system, one must have access to capital, for without capital one cannot participate in the capital structure or equity base of the United States. According to Jack Kemp in a recent testimony to the Senate Finance Committee on Enterprise Zones, he stated that African Americans owned less than 12 percent of the equity of the United States, even though we are 13 percent of its population . At a time, when the U.S. needs to grow its economic base, it cannot afford to continue to ignore a major segment of its market. The African American community (32 million strong) that earned $ 300 billion in 1991. The African American community that accounted for 10 percent of domestic automobiles purchased in the U.S. (Chryslers share of the U.S. Market is 10 percent). If African Americans were to be spun-off as a Nation based on income earned, it'd be the 9th richest country in the world. The $300 billion figure compares to the amount ($300 billion), as per Ross Perot, the U.S. spent for the same period defending NATO . The African American market is substantive, and should not be ignored by American Corporations, when they are seeking an increase in market shares. If the U.S. can use its resources to teach the Russians and Eastern Europe how to be capitalists, it should also teach African American citizens how to be capitalists. It is in the national interest of the U.S. to do so. Today, U.S. corporations go abroad to find cheap labor to increase their market shares at the expense of urban and rural America. There appears to be this sense in the Nation, that urban areas or powerless segments of the country can be ignored. It is not being realized, that as the urban centers deteriorate, so will the suburbs. It is only a matter of time, when there will not be a hiding place for anyone. Presently cities, counties, townships , etc. are pitying their citizens vs. one another because of a shrinking tax base, reduced revenue sharing from the Federal Government, and due to an idle workforce , that looks to the state for some type of "non productive entitlement. ” What happens then (as is now) when states and cities have no one else to tax? What happens when the tax base cannot support the debt capacity of tide local or state Government? How can one help to stem the tide? Ethnic balkanization becomes more prevalent, local schools and law enforcement agencies become overloaded and we then start to invest our local resources in nonproductive prisons. One way of growing the economy to help expand the tax base is by doing the following: A. Making it possible for "qualified entrepreneurial borrowers" in the inner cities to have access to "sufficient credit" to make a "feasible project" operate so it can in turn create jobs and hire neighborhood residents. Too often "inadequate loans" are made to selected "incompetent minorities, " so the system can have Pygmalion statistics in the negative to justify benign neglect. B. Duplication of Southshore type banks in the inner cities and rural areas to provide "viable Ventures" in distressed area's access to capital, so they can remain as going concerns . Too often, commercial banks, savings and thrifts will accept cheap deposits from inner-city residents, but will invariably refuse to loan it to them due to perceived "higher risk problems. " For example, in Grand Rapids, where Southside Bank is in formation, the inner-city is populated by 85,000 citizens, 35,000 of which are African Americans; in 1989 the commercial banks' savings and thrifts garnered $508 million in deposits, but made only 1 percent of the amount in loans to the area: (1) Experienced business persons even with signed City or State contracts could not get loans. (2) Skilled persons purchased businesses commensurate with their expertise and cannot obtain working capital loans. (3) Professionals such as dentists, doctors, lawyers, teachers, etc. have a difficult time getting a loan approved and gave up. 87 (4) African Americans and Hispanics depositors have a difficult time getting a loan approved even when their savings exceeds the amount requested to be borrowed. (5) Residents have a tough time getting a conventional mortgage or a home improvement loan. (6) African American and Hispanic contractors and developers cannot obtain financing for their projects. On the basis of the above, African American business persons have a difficult time becoming job creators, or employers and be in a position to hire other minorities. Complicating the situation further, are the following circumstances: The tendency of African Americans to boycott themselves- not doing business with one another-for example; in 1989, African Americans in Grand Rapids earned $208 million but spent most of it outside the community-contributing further to non-job creation-confirming the notion, that African Americans have always been on the consumer side of the equation as opposed to the supply side. Mark Green, Commissioner of Consumer Affairs for New York commissioned a study on the spending habits of African Americans and Hispanics in New York compared to the Asian community. The results were interesting: 1. For each $ the Asian person brought to his community, it turned over 16 times before it left. Why? The Asians own their own banks, factories, real estate, stores, restaurants, etc. They provide jobs for one another. 2. In the "African American community” and the "Hispanic community," it had the "rubber effect." As soon as the $ came in, it bounced back out-African Americans own very little land and tools of production. Going back to the Middle Ages, the power brokers and decision makers were the landowners, the churches, and the class that produced goods and services. 3. Us African Americans still do not understand the meaning of the word "Freedom. " Our concept ofFreedom is still confined to Civil Rights. We still don't get itthat the color of freedom is "green money"—not which end of the Bus we ride onnot what names people call us-but what we own, what we manufacture-if we own the Bus, it does not matter which end we ride on-if we own the "Hotel" and the clerks call us names we can reprimand or fire them. 4. The Corporate Network views the African-Hispanic American people strictly as consumers-a place where they send delivery trucks to sell their products. There is no reciprocity-for example, investing in the people or businesses that are in the area. Unfortunately, the African American is not as sophisticated as the Jewish American to retaliate by doing "selective buying." In the Jewish Community anyone that is inimical to the Jewish people or the State of Israel is boycotted. 5. The African American community does not benefit from the community reinvestment act for the following reasons: A. Weak reviews or audits by pertinent Government regulators of Banks and their compliance with C.R.A. B. The corporate citizens are provided with safety valves through community organizations such as local NAACP, Urban League, some churches, etc. to underwrite annual dinners, little league teams, etc. Investment into meaningful or substantive projects that would provide meaningful jobs, so a person can support a family are not undertaken. The corporate citizen fills his C.R.A. Portfolio with these meaningless public relations activities, in addition to writing it off as a tax deduction. The persons in whose name this was done are no better off for it. C. Most African American community members do not understand the C.R.A.— much less monitor it. The banking community has found ways of circumventing the C.R.A. through mere public relations. D. The African Americans have abdicated themselves to "helplessness" and "confusion." We are going to need competitive assistance to start turning things around. BARRIERS ENCOUNTERED IN THE FORMATION OF COMMUNITY BANKS A. Established law firms and consulting firms cannot be obtained for Chartering and writing of the Offering Circular due to prohibitive fecs. Established law firms have expertise and networks that the "Entity in Formation" cannot benefit from, unless it has a Godfather to pay for it. B. The utilization of affordable lawyers delays the process for the following reasons: (1) Lack of expertise in the Chartering of new or De Novo Banks. (2) Lack of sufficient business and banking experience on the prospective banks Board (Southside Bank was initiated by community activists) . 88 (3) Understanding of the distinction between a social agency and a “for profit” venture . C. Typically the offering is small and not attractive to Brokerage houses for marketing. The stock has to be marketed by the Executive and Board members who are hampered by the following: (1) Limited advertising resources. (2) Educating members of the community who would be the beneficiaries of the banking services. (3) Board members invariably have full-time jobs and do not have much time to devote to stock sale. Consequently, stock sale falls squarely on the shoulder of the Executive. D. The time period of one year for capitalization is too short-in minority communities, it should be for 2-3 years. I would strongly recommend that the Banking laws be amended. E. Lack of cooperation and concern on the part of some of the following: (1) Most members of the local financial community who typically benefits from tax abatements, etc. (2) Most members of the religious community. (3) Middle class minorities (African and Hispanics). (4) Municipalities and agencies. F. Lack of sufficient financial resources (such as a credit line) to weather the swings in stock sale. Only the fees from stock sale can be used for administrative purposes. G. Bankers manage "risk" to make a maximum return. Unfortunately, the "perception" is that, that "risk" cannot be in an African-Hispanic atmosphere. TESTIMONY OF EDWARD H. MCNAMARA, WAYNE COUNTY EXECUTIVE FEBRUARY 1, 1993 Honorable Chairman and Members of the Committee: I would like to explain why Wayne County has chosen to establish a community development bank as part of its revitalization strategy. In addition, I will discuss the challenge faced in Wayne County's older communities and suggest ways in which the Federal Government can support emerging development banks such as the one we hope to establish. In other testimony given today and at previous hearings, you have heard representatives of Shorebank Corporation discuss their work with organizations throughout the country who are exploring the establishment of development banks. The Wayne County Department of Jobs and Economic Development is one of those organizations. We have been working with Shorebank Advisory Services for nearly two years to develop a business plan for a development bank based on the Shorebank model. I hope to convey to you today Wayne County's vital interest in forming a development bank. I. WHY WAYNE COUNTY HAS CHOSEN A DEVELOPMENT BANK As part of its economic development strategy for the older neighborhoods within and surrounding the city of Detroit, Wayne County has chosen to pursue a development bank holding company. The important characteristics of a community development bank include: • Combining a bank with entrepreneurial, non-bank affiliates and provides coordinated, comprehensive interventions for community development, not just the provision of credit. • Leveraging private sector resources and capital by accepting deposits and turning them into development credit. • Targeting credit, capital, and market information into a geographically defined area to shift perceptions of both residents and outside capital. • Delivering a wide array of private and public sector resources into disinvested communities by blending foundation capital, credit enhancements, tax credits, and other existing programs in innovative ways; • Conveying a symbolic legitimacy and authority, which can convince residents of its commitment and confidence in the community and encouraging them to invest their savings, time, and effort in their neighborhood. With its detailed knowledge of the community and the ability to tap multiple tools and resources, a development bank is an entrepreneurial and capable partner to Government's standard array of incentives and resources . The challenges facing the older communities of Wayne County are similar to those facing disinvested communities in other American cities . In response to the glaring need in our own communities, Detroit's major banking institutions have committed 89 more than $1.6 billion dollars for investment in Wayne County's older communities. Our markets have nearly ceased to function, however, and very little of these committed funds have been disbursed. The gap between bankable transactions and the reality of these real estate markets has grown too wide. Three Major Problems We have three major problems: non-functioning real estate markets; minimal job creation through business development; and deteriorated social fabric. Each of these is addressed by one or more of the operating units of our proposed development bank: a for-profit real estate developer, a full-service commercial bank; and a nonprofit affiliate engaged in housing assistance, small business support services, and non-bank business credit. First, real estate markets have essentially ceased to function in these communities due to the sustained lack of activity. In 1989, only one mortgage loan was made per 446 housing units in Highland Park, compared to 5 or 6 mortgages made per 100 units in healthy markets. Only 300 mortgages were made in 1989 in an area of 140,000 persons. The perceptions of crime, violence, and the poor future of these communities has inhibited new investment in homes and businesses by those inside and outside the neighborhoods. While the areas of Highland Park, Hamtramck, and the outer edges of the East Side of Detroit are characterized by low levels of lending and investment, the housing stock in these areas is very affordable and is a strong base on which to build. To create visible change on a scale that shifts the perceptions of residents from decay to opportunity, the real estate developer will need to change the microclimate within individual neighborhoods. This can change occurs by undertaking large scale, top-down rehabilitation and new construction projects that have a visible and dramatic impact on the neighborhood. Like any other for-profit development company, the developer will combine an array of Federal, state, and private resources, including collaboration with the Michigan Housing Development Authority and use of the Low Income Housing Tax Credit. By carefully choosing the locations of such projects, the developer can achieve a critical mass of renovation and visible change. Shorebank's experience in Chicago has been that when a critical mass of development activity is achieved, a group of housing entrepreneurs emerged and began acting in their own self-interest to approach the bank for the financing to purchase and rehab nearby, smaller scale properties. Although the markets in Wayne County are different from those in Chicago, the following fundamental principle still applies: the creation of attractive housing can change the expectations of local residents and encourage them to invest their savings, time, and energy in the community and in home ownership. Second, job creation through the growth of small, entrepreneurial firms has been minimal compared to the volume of jobs lost in manufacturing and industry. The population of these communities has declined by half since the 1950's, with much of that loss occurring in the last decade. This dramatic population drop has limited the number of service and franchise firms in these areas, two sectors which have been a source of job growth in other markets. The availability of ( 1) commercial loans through the bank, along with aggressive use of SBA-guarantees and other credit enhancements, and (2) business support services and non-bank risk capital through the non-profit affiliate will provide a continuum of support for expanding small businesses. These business support services will focus on marketing, new product development, and financial management, complementing the more general technical assistance resources already in place in the Detroit area. Third, the social fabric in these communities has been deteriorating over time and must be restrengthened. The non-profit's housing assistance activities will include block clubs, community safety, and events to sponsor neighborhood pride. These neighborhood-based activities help restore the bonds among neighbors, reestablish communication networks, and help the restoration of social fabric. Selection ofTarget Areas is Key A development bank serving these communities will not have an easy task. Changing both reality and perceptions (such as deep-seated pessimism about the future of these communities) will take time and persistent effort. To be profitable and self-sustaining, a development bank will have to select its niche markets very carefully and husband its capital prudently by concentrating its activities in small neighborhoods until they are stabilized and from there, branch outward. Encouraging investment rather than disinvestment is critical to achieving change, but very difficult to accomplish. Selecting a target area is the hardest step in designing a development finance institution. The location of a development bank dictates its design, the organizational 90 structure, the strategies, and the tools it employs. Although the principles of development banking are transferable, a development institution must reflect and build upon its local context. For example, our targeted communities in Wayne County have an abundance of low-cost real estate that makes home ownership possible for households earning less than $20,000 per year. Focus groups indicated that some demand exists for housing within certain sub areas within the target communities. The housing stock is attractive, the cost of land and buildings is low, and rehab expenses are minimal. In Wayne County, the primary strategy will be to target specific opportunities in housing development within the proposed target communities of Hamtramck, Highland Park, and portions of the East Side of Detroit . In choosing the target areas, management must balance the need for the bank to maintain its profitability with the opportunity to undertake large scale, non-bank development projects in areas of need. Certain parts of these communities have experienced such prolonged and severe disinvestment that they cannot support a self-sustaining development bank. II. WHY A DEVelopment Bank COMPLEMENTS CONVENTIONAL Lending A comparison with the purposes of conventional banks may help clarify the unique properties of a development bank for community investment. As discussed above, development banks bring much more than credit to the task of community revitalization. There are several reasons why conventional banks should not be expected to do the same. 1. Community development lending is not their primary mission. Development banks have a specialized mission, structure, management team, and operating plan that all focus on restoring healthy market forces that transform underinvested communities. These institutions evaluate their performance on both financial return and development outputs. If only one of the two goals is met, management has failed to walk the tightrope. In contrast, conventional lenders have a clear primary obligation to generate a financial return to their shareholders. Community development lending is a sideline that is not part of their core business . 2. Conventional banks do not engage in demand-generating, non - bank activities that compliment the provision of credit. Through its non-bank activities, a development bank provides support to individuals to narrow the gap between the bank product and what the market needs. If the market needs educating about how to use the product, or how to prepare for eligibility, the non- profit can answer their questions. If the market needs assurance that the community is improving and an investment in a home makes sense, the actions of the real estate developer can send them a signal . 3. There are legitimate disincentives for conventional lenders. Distressed economies need smaller loans, a detailed knowledge of local market conditions, and sophisticated lenders who can judge the intent and ability of a borrower to repay. All of these increase the costs of making these loans . They reduce profits and are therefore less attractive to bank management than lending in more familiar and more profitable markets. 4. Consolidation and heightened competition among banks have desensitized them to the credit needs of local communities. As industry consolidation has created regional institutions and bank mergers, credit policy decisions are now made in a downtown office and applied in a uniform way to all branches regardless of their local market . The pressure to achieve economies of scale and reduce costs focuses management decisions on uniformity, high volume, and efficiency of loan approvals and administration . Although Detroit has some of the best-capitalized banking institutions in the country, recent mergers and consolidations have greatly reduced the number of small banks serving the city and its adjacent communities . 5. The shift to uniformity has constrained character lending within larger institutions, as credit decisions are made on the basis offinancial ratios and collateral values. This trend is exacerbated by the regulators who are scrutinizing portfolios for signs of " poor" credit decisions . Banks tend to be product-driven, but when they offer a new first-time homebuyer product and there is minimal demand, their market expectation is confirmed. The economic challenges facing the older Wayne County communities will require some "heavy-lifting." A development bank will need to work together with conventional banks and private sector leadership. The activities of development banks and conventional lenders are complementary . Development banks nurture and cultivate demand for credit where none existed previously. As the volume of transactions increases and conventional lenders become more familiar with a new market, they can begin to compete with the development lender. From this vantage point, it appears as if Shorebank has kept shifting its niche in response to the changing conditions . The bankers with whom we have met to discuss the development bank for Wayne 91 County concur that development banking is a niche business. Since we began discussing the business plan with individuals from the private sector, we have received several telephone calls from individual bankers expressing their support for the creation of a new type of financial intermediary. III. THE ROLE OF GOVERNMENT As Government, we at Wayne County have had to recognize our limits in the creation and operation of a development bank. Wayne County considers itself to be the convener, bringing the Shorebank model to Wayne County and convincing private sector actors of its merit as an additional tool in the economic development arsenal. Our lessons from the experience of Shorebank include: • The most effective economic development institutions are market-driven and accountable to the customers and markets they serve. • There must be a professional management team with a single focus on renewing the underinvested communities in which it works. • An apolitical institution maintains continuity despite changing administrations and keeps its credit judgment separate from any political influence. • A development bank is unique in its ability to combine and deliver a wide range of public and private sector resources to disinvested communities. This last point merits some discussion. Too much effort in turning around urban America has focused on the demands of the political cycle and on programs designed to meet isolated needs rather than to coordinate a response to interrelated problems . Economic development programs tend to be fragmented, run by separate Government agencies, and often with incentives for shallow, short-term investments that fail to cumulate into lasting change. With rare exceptions, there are few institutions in place to drive a long- term development agenda for neighborhoods. These communities have fallen into this disinvested condition over three decades; it will take a sustained, long-term investment to reverse it. Specific Recommendations It appears that Shorebank has achieved a great deal with few special privileges and with long-term, patient capital. If experience is any guide, perhaps the Committee should keep in mind 4 or 5 guiding principles as it drafts this legislation: • First, do no harm. The fundamental premise of a development bank as an entrepreneurial, adaptive, organization able to tap multiple resources and deliver them to disinvested communities must be preserved. Government assistance should take care not to blunt the market-driven approach, its entrepreneurial use of resources, or its ability to define niche markets that evolve over time. • A separate regulatory structure for development banks sounds suspiciously like the spread of unnecessary bureaucracy. The standards for operation should remain as high as those for other banks. • Matching Government funds for private capital commitments will allow these institutions to build a sound capital base, a constraint that has limited the creation of new development banks. Such matching commitments should be no more than 1:1 and public funds should not exceed more than 49 percent of total bank capital. Subsequent requests for additional capital should be based on performance of the recipient. • Grant funds to the non-profit affiliate could also match private sector commitments. • The organizational and legal costs for a development bank are significant, as are the costs of preparing management and preparing fund raising materials. Grant funds to finance these startup costs for individual development banks might be committed up front, yet disbursed in increments based on achievement of "milestones." • There should be some funding for the development of a support system for emerging development banks, such as partial funding for a training institute or internships for management existing development banks, or other forms of management and staff development. In conclusion, this country has established public purpose, permanently capitalized, professionally managed institutions to carry out activities important to society. Museums, hospitals, and universities are all examples. Perhaps it is time to create similar institutions for urban neighborhoods . 70-832 0 - 93 - 4 92 TESTIMONY OF PAULINE NUÑEZ-MORALES, EXECUTIVE DIRECTOR, THE NEW MEXICO COMMUNITY DEVELOPMENT LOAN FUND FEBRUARY 3, 1993 Thank you, Mr. Chairman, and members of the Senate Banking Committee. My name is Pauline Nuñez-Morales and I am the Executive Director of the New Mexico Community Development Loan Fund, a statewide organization. Today I am representing my own organization and the National Association of Community Development Loan Funds (ÑACDLF), an association representing 41 community development loan funds. NACDLF is active in an ad hoc coalition of community_development financial institutions (CDFI's) that also includes the Association for EnterpriseOpportunity in Chicago, IL, the Center for Community Self Help in Durham, NC, Community Capital Bank in Brooklyn, NY, First Nations Development Institute in Falmouth, VA, the National Federation of Community Development Credit Unions in New York, NY, and Woodstock Institute in Chicago. This coalition comprises representatives of all segments of the CDFI industry that has pioneered the business of community development lending over the past several decades. We have prepared a position paper comprising our best thinking at this time on the issues involved in setting up a Federally supported network of CDFI's . A copy of the paper is attached to my testimony. The Work of the New Mexico Community Development Loan Fund The New Mexico Community Development Loan Fund (NMCDLF) is a private, non-profit financial intermediary created in 1989 and dedicated to the economic and social empowerment of the people of our state. The fund borrows capital from 29 socially responsible investors and lends it in support of affordable housing, community-based business, basic human services, and community development in general. NMCDLF is the only community development lending vehicle in a state that has one ofthe highest percentages of people living below the poverty level in the United States. As a primarily rural state, New Mexico faces a unique set of economic challenges for many people, major markets are distant, there are limited job opportunities, and access to all types of services (particularly, financial and public services) is inadequate. Over a third of the state's population is Hispanic. Native Americans comprise 10 percent of the population . Both populations make up the majority of rural residents. Within these traditional communities, language and racial barriers can contribute to their inability to access traditional capital sources. The NMCDLF's mission is to help create long-term solutions to poverty by placing resources back into communities to create jobs, retain community services, and improve housing opportunities. To this end, the fund has helped to expand rural health facilities, support organic agriculture, reduce program costs for transitional housing groups, and expand rural enterprises. NMCDLF currently has $820,000 in capital under management. Our capital has come from Catholic women religious groups, Protestant religious groups, Jewish synagogues, foundation program-related investments, corporations, and Federal economic development programs, as well as individuals. We have eleven loans outstanding totaling $209,694. Cumulatively, we have made 17 loans totaling $284,571 . All loans are current, and the fund has experienced no losses to date. Like other NACDLF member funds, our role is: (1) to provide credit to economically disenfranchised and disinvested communities and individuals (2) to provide technical assistance to help borrowers plan and implement successful development projects (3) to leverage financing from public agencies and conventional lenders (4) to give people and organizations the skills, credit histories, and development track records necessary to enter and succeed in the mainstream financial markets. I would like to give you a few examples of how the NMCDLF works. • Homemakers Association of Amalia and Costilla (HAAC) supports the development and training of local women. A $5,400 NMCDLF loan enabled HAAC to purchase industrial sewing machines to expand a cottage industry creating Southwestern fashions. The new machines helped the organization diversify the kind of contracts it could work on, hire an additional person, and support a unique business venture in an isolated rural Hispanic village in northern New Mexico. The business has diversified its product line and has hired two additional women. 93 • We have also participated with other institutions in making loans. Recently, we participated in a loan to a non-profit housing organization, St. Elizabeth's Shelter, that purchased a nine-unit apartment building to house families in transition in Santa Fe. A locally owned bank provided a $ 170,000 loan for permanent financing, and a local donor contributed $50,000 for the down payment. NMCDLF provided a short-term $80,000 loan that helped to make the project happen. Concilio Campesino del Sudoeste, Inc., provides a variety of health and human serves to more than 300 people per day, most of who are farm workers or elderly residents of Doña Ana County in southern New Mexico. With a $25,000 loan from the NMCDLF, the Concilio has been able to correct health safety code problems and add 1,500 square feet to its 8,000 square foot facility. The threeyear, 9 percent loan will be repaid by rent revenue paid by La Clinica de Familia, Inc., the rural, migrant health care provider that will occupy most of the new space, and by other tenants. The Concilio is the lone health, social services, and community center. Without it, area residents-many of whom do not have cars- would have to travel to the town of Las Cruces, 18 miles away. As you can see, the NMCDLF lends for both housing and business projects, recognizing that distressed communities need to develop both aspects of their infrastructures. We provide as much technical assistance as is required to ensure that our loans and the projects they fund are properly planned and managed. This assistance often precedes underwriting and continues through the life of the loan. Our underwriting criteria are rigorous but they are not standardized in the way that underwriting is for conventional lending. They are individualized to reflect the unique characteristics of differing communities and borrowers. Our experience highlights the fact that conventional approaches to risk assessment and security must be re-examined when serving borrowers with little or no credit history, business or development experience, or collateral. Our model is self-sufficiency. We recognize that traditional Federal assistance programs meet the needs of some individuals, but we focus our work on projects that will enable individuals, institutions, and communities to achieve economic and social independence. Our borrowers gain not only a home or a business or a decent income but also the skills they need to participate fully in the mainstream economy. This approach is different from traditional human service analysis which tends to look at what is wrong with a community to identify its needs. As a community development organization, we go beyond that and question what is right with a community-what are its strengths-and use our dollars to enhance what is there. The Loan Fund Industry NMCDLF is a relatively young and small organization in the loan fund industry. The 41 NACDLF member loan funds have loaned more than $ 100 million, which has leveraged $760 million in public and private capital to finance 15,000 housing units and to create 3,500 jobs for poor Americans. NACDLF members' loss rate on loans is less than 1 percent. Within our chip there is a growth ladder on which small funds seek to grow into large funds, and some of our larger funds are exploring the possibility of adding depository arms and other financial and technical services . NACDLF members serve large metropolitan areas like New York, NY, and Los Angeles, CA, while others work statewide (e.g., New Hampshire, Vermont), or on a multi-state basis (e.g., upper midwest, mid-Appalachia). NACDLF's strongest member funds such as the Delaware Valley Community Reinvestment Fund (DVCRF) in Philadelphia, PA, the Low Income Housing Fund ( LIHF) in San Francisco, CA, the Boston Community Loan Fund (BCLF), and the Cascadia Revolving Loan Fund in Seattle, WA, provide leadership for the NMCDLF and other growing loan funds. They are the pioneers in our field, and their experiences and success are models for growth in our industry. They and other loan funds have demonstrated that non-profit, non-depository revolving loan funds can: • Aggregate significant amounts of private capital from individual and institutional Social investors. • Successfully fill gaps in credit markets in urban, rural, and Tribal communities. • Work hand-in-hand with conventional lenders to their mutual benefit. • Finance new forms of ownership such as mobile home park cooperatives and land trusts. These institutions are now planning to significantly increase the scope of their efforts. For example, DVCRF is studying the possibility of adding a depository arm. My colleague from DVCRF, Jeremy Nowak, is here today and would be glad to answer your questions about these plans. Other NACDLF members considering similar plans include the Boston Community Loan Fund in Massachusetts, the Federa- 94 tion of Appalachian Housing Enterprises in Berea, KY, the Cascadia Revolving Loan Fund in Seattle, WA, and the Vermont Community Loan Fund in Montpelier, VT. NACDLF's largest member, the Low Income Housing Fund, currently manages $20 million of private capital from social investors, including the Ford Foundation, Metropolitan Life Insurance Company, and the Prudential Insurance Company. LIHF believes that adding a depository arm is not the only way for it to meet its goals . Instead, LIHF has concentrated on building bridges between conventional Tenders and distressed communities. Toward that end, the LIHF has created several bank pools in northern California, Los Angeles, and New York City totaling some $21 million. These pools reduce the risk and costs of low-income lending for conventional financial institutions while significantly expanding the credit available in some ofthe poorest communities. At the other end of this growth ladder, new and developing funds such as the NMCDLF are models for emerging loan funds and start-up efforts in places like Maine, western New York, Delaware, South Carolina, and Chicago. We share our experiences through an Annual Training Conference and mentoring programs sponsored by NACDLF. Seven years ago, the 18 loan funds then in existence realized that they needed a national association to set performance standards for the industry, offer financial and technical support, and provide training necessary for the growth ofthe industry and the creation of new loan funds in under-served communities. Loan funds are uninsured non-profit intermediaries whose growth is contingent on continued strong performance. Today, the National Association of Community Development Loan Funds has in place rigorous performance criteria based on the "best practices" of the industry over the past ten years. NACDLF enforces these performance standards through: • Member fund evaluations to assess organizational capacity, management systems, financial strength, and lending performance. • Performance-based loans and grants through which NACDLF advances loan capital and makes grants to member funds to build institutional capacity and financial strength . • Technical assistance and training through an Annual Training Conference, regional workshops, technical assistance publications, and work with individual member funds. NACDLF believes that a performance-based lending and grants program should be the model used to create a national network of community development financial institutions. It fosters discipline in business activities while allowing institutions the flexibility to provide loan products and related services that are appropriate to the communities they serve. Let me explain how our performance-based lending and grants program works. NACDLF makes unsecured term loans from its Central Fund to help members finance development projects at the local level. These loan moneys from national investors such as the Episcopal Church and the John D. and Catherine T. MacArthur Foundation can only be accessed once a member fund has achieved certain performance objectives. In addition, NACDLF recently received a $1 million start-up grant from Citibank, N.A., to launch an Equity Grants Program to build the net worth of member funds. This program Is particularly important to new organizations such as the NMCDLF, which does not yet have the financial strength to qualify for a loan from NACDLF's Central Fund. These moneys are disbursed to the loan funds as loans, contingent on the fund meeting certain performance objectives. At that time, the loan converts to an equity grant which enhances the ability of member funds to attract private capital. NACDLF plans to increase the Equity Grants Program to $25 million. It is currently negotiating with other potential corporate and foundation donors. For loan funds, as for all ČDFI's, equity is critical to continued growth and to the establishment of new institutions. Equity allows us to take the risks inherent in serving first-time borrowers and provides the earnings to pay for the technical assistance so critical to first-time borrower success. Lack of equity capital is the single greatest barrier to the growth and development of CDFI's at all levels. NMCDLF has only $130,000 in equity capital at present. NACDLF requires member funds to have at least a 20 percent capital to asset ratio. Increasingly, NACDLF and its member funds are realizing that a 30 percent to 50 percent capital to asset ratio may be necessary to serve all borrowers and for CDLFs to raise large amounts of private capital. I know for NMCDLF to serve the start-up, small businesses critical to the revitalization of New Mexico's rural economy, achieving a capital to asset ratio of 50 percent is imperative. Public entities are the only reasonable source for these dollars. Unless CDFI legislation 95 deals with this issue, NMCDLF, DVCRF, LIHF, and others will not become the large-scale development finance organizations needed to transform America's poorest urban centers and rural communities. Strategic Federal Support On behalf of my colleagues within NACDLF, I want to offer some comments on the creation of a national community development lending initiative. Collectively, the existing CDFI industry provides a baseline against which the progress of a Federal program could be measured. Capitalized with more than $700 million-much of which is raised from within the communities or constituencies they serve development banks, credit unions, and loan funds have extended more than $2 billion in loans. Loss rates are comparable to those of the best conventional lending institutions. We offer a solid foundation for a bold community development lending initiative that might include new institutions, community organizations, conventional lenders and others. Our mission before you today is to help build support for a CDFI industry that is: (1) sustainable and growth-oriented, (2) committed to lending in rural, urban, and Tribal communities that have been under-served in the past, (3) complementary to lending by conventional lenders, (4) operated under a demanding system of performance-based investment. The Ad Hoc Coalition of CDFI's has set forth six key principles in meeting credit needs in lower-income communities, and NACDLF endorses these principles: 1. Community development "banks" should be defined to include the spectrum of CDFI's comprising community development loan funds, community development credit unions, micro-loan funds, and community development banks. 2. Expand the scope of community development lending beyond small business credit to also include housing credit and consumer financial services. 3. Consult experienced CDFI's in crafting legislation, as the Committee is doing today and has done over the past several months, and in setting up and evaluating the CDFI network. 4. Emphasize expansion of existing CDFI's rather than simply undertake wholesale efforts to create new development banks. 5. Recognize that successful development lending institutions are built over time and with incremental performance-based financial support. 6. Clarify the different interests and responsibilities of conventional lenders, public agencies, and CDFI's. NACDLF and the ad hoc coalition strongly believe that the Community Reinvestment Act should be strengthened and expanded. The demand for credit in under-served communities is beyond the scope of any community development lending program and will remain so for the foreseeable future. Conventional lenders should be required to meet quantifiable lending goals. Investment in this network of community development financial institutions should not exempt banks from fulfilling their full obligations as lenders under the Community Reinvestment Act. Last year, the Federal Financial Institutions Examination Council explicitly stated that banks could qualify for CRA credit by supporting and entering into partnerships with loan funds and other CDFI's, as a growing number of banks are doing. This is not and should not be an either-or proposition, however. Banks that are involved with CDFI's must also continue lending directly into the communities they serve. In addition, the Federal Government could support community development in general by extending the reach of the CRA to other financial institutions such as finance companies, money market funds, insurance companies, and mortgage banks that are not covered by ČRA. We also believe that creation of a Federal network of CDFI's must be linked to future financial support for and regulation of the conventional financial industry. The substantial restructuring of the conventional industry over the past two decades has been made possible through myriad Government subsidies (e.g., Federal deposit insurance, state insurance guarantee funds, Federal Reserve Discount Window borrowings, etc.). Government subsidies and new powers should be granted to the conventional financial industry only if it meets quantifiable community lending objectives and provides ongoing financial support to the developing national network of CDFI's. Funding We believe that Congress and the Clinton Administration must make a clear financial commitment to the CDFI system to signal their support for the long-term viability of the industry, but this should be just one part ofthe funding mechanism. The $850 million figure reportedly under consideration by the Administration for disbursement over five years seems to be at an appropriate scale . We respectfully suggest that this money should be committed primarily as equity support in increas- 96 ing amounts over the five years in accordance with a performance-based lending investment program that provides support to all rungs of the CDFI industry growth ladder. Those CDFT's that perform up to industry standards would gain access to increasingly large amounts of the $850 million. This ensures that the money is not distributed without due accountability measures. Federal support is just one part of the funding that is necessary for this effort, however. No less important are below-market and long-term deposits and loans that afford CDFI's the ability to properly underwrite their loans, creation of a human capital development training program to prepare a new and expanded generation of CDFI professionals, and support for technical assistance and new loan products customized to individual communities. We see this funding coming, as I stated, not only from the Federal Government. CDFI funding should also draw on the public responsibilities of federally insured and subsidized conventional financial markets. Those institutions that benefit from public subsidy should be expected to contribute in various ways to meeting credit needs they are not addressing directly. The ad hoc coalition of CDFI's has identified several possible financing mechanisms that merit consideration: • Commercial bank commitments of equity capital and other support as an outcome of CRA negotiations or mergers that create mega-banks. • A share of the profits from appreciation of federally sold assets (e.g., a percentage recapture levy on Resolution Trust Corporation properties). • A share of profits from Government-sponsored enterprises such as Fannie Mae and Freddie Mac. • CDFI set-asides within major legislation to bail out the savings and loan industry or to inject capital into other parts ofthe financial services industry. We also support efforts to encourage commercial financial institutions to provide long-term, low-cost capital to the CDFI sector. Measures such as requiring conventional lenders, pension funds, investment banks, insurance companies, mortgage companies, and finance companies to place a small proportion of their overall assets with CDFI's would yield enormous public benefits in the form of jobs , affordable housing, and increased ownership opportunities. It would also underscore the fact that commercial financial institutions have obligations to see that community credit needs are met. Tax incentives providing tax-free interest to individuals who make below- market investments in CDFI's would give investors (or depositors) the equivalent of marketrate returns while ensuring a steady capital flow for the CDFI's. Individuals are already the core support for many CDFI's, but a strong incentive such as this would substantially strengthen the CDFI industry. Human Capital Development Our greatest resources are our board, our staff, and our committed volunteers. The NMCDLF currently operates with only two employees and as we grow one of our greatest challenges will be recruiting and training loan and technical assistance officers. This challenge is shared across the industry. Efforts to create a national system of community development financial institutions will only be successful if a generation of directors, managers, and loan officers can be recruited and trained to operate these intermediaries . Development lending and public purpose bank management require specialized knowledge and technical skills , strong social commitments, and extensive community experience, all of which differ in important ways from the skills needed to run a conventional financial institution. Community development lenders should undertake, with Federal support, several initiatives to develop the next generation of community bankers and trustees needed to operate and to govern an expanded network of community development financial institutions. These initiatives could include : • Creation of a three-year internship/apprenticeship program at community development financial institutions . This internship would be similar to in-house conventional /investment bank training programs but would also attend to the economic, social, and intellectual formation of participants. This program could dovetail with President Clinton's plans for a National Service Corps by placing talented young adults in training for productive careers in community development and community development finance. • Forging cooperative training agreements with select university business schools and conventional financial institutions to complement the apprentice program outlined above. • Sponsoring regular seminars on capital access, community leadership, public investment, and economic democracy issues for CDFI board and staff members. 97 The Federal program also should include a research program to assess the longterm economic and social issues affecting the CDFI industry and the communities its members serve. Corresponding Federal Policy Changes An effort to create a national network of CDFI's would benefit by a series of related administrative and legislative initiatives: • Simplify public sector credit enhancement programs to non-profit CDFT's. Partial and full loan guarantees, for example, could significantly increase the ability of CDFI's to leverage both public and private investment dollars. Similarly, non-depository CDFI's could increase their business lending if SBA rules were modified to simplify the requirements on non-bank lenders. This adaptation would also increase the number of minorities, women, and rural businesses receiving SBA support. • Require Government-sponsored enterprises (GSEs)—Fannie Mae, Freddie Mac, Ginnie Mae to develop customized secondary market programs for housing and business loans originated by CDFI's. To date, GSE's have been almost completely unresponsive to CDFI's . CDFI's performing loans are judged by standardized underwriting criteria that are largely irrelevant to CDFI's lending market. CDFI's cannot grow and prosper unless an active secondary market is fostered for their loans. That concludes my prepared testimony. Thank you for this opportunity to discuss the work of the New Mexico Community Development Loan and our peers in NACDLF. I would be pleased to answer any questions you may have. TESTIMONY OF RONALD L. PHILLIPS, PRESIDENT, COASTAL ENTERPRISES, INC. COMMUNITY DEVELOPMENT CORPORATIONS AND THE COMMUNITY REVITALIZATION SYSTEM FEBRUARY 3, 1993 Introduction Senator Riegle and members of the Senate Banking Committee, thank you for inviting me to testify on the proposed Community Revitalization System. My name is Ron Phillips. I am President and principal founder of Coastal Enterprises, Inc., a nonprofit community development corporation located in Wiscasset, ME. The Community Revitalization System is a strategic step to accelerate job-creating community development initiatives. It is an investment in America that will grow businesses, create jobs, build housing, and generate assets for low-income and working families. The return on taxpayer investment will multiply, and will recycle year in and year out. We are especially interested how the Community Revitalization System will benefit Maine, including community development banking, partnerships with existing banks, access to venture capital, and resources for micro and community loan programs. I encourage your support for, and crafting of, legislation that is both flexible and inclusive, and that will provide a menu of opportunities for community development banks, credit unions, CDCs, micro and community loan funds, a network which enthusiastically awaits a resurgence of Federal support for their efforts. Purpose of Testimony As a practitioner of community development for over 15 years, and board member of the National Congress for Community Economic Development, the 325 member trade association for CDCs (please refer to the attached recent membership list), I want to share with you the exceptional accomplishments of my colleagues and CEI in community development, and our readiness as a national industry to partner with the Federal Government's Community Revitalization System. My remarks will be brief, focusing on the legacy of CDCs, CEI's accomplishments, and recommendations. The Legacy of Community Development Corporations What are CDCs? CDCs originated in the latter 1960's with the Title VII amendment to the Economic Opportunity Act of 1964-to develop businesses, housing, commercial real estate, and create economic opportunities for disenfranchised residents. This amendment was introduced in the U.S. Senate by the late Senators Robert Kennedy and 98 Jacob Javits. What we contemplate today for a national Community Revitalization System is owed, in great part, to the accomplishments of CDCs. CDCs share in common the mission of targeting development to distressed urban neighborhoods and rural communities and regions to create jobs, decent housing, education and training, and social services. CDCs are in virtually all States. Their development activities are diverse and responsive to the needs of their communities. They develop day care facilities, community health centers, affordable and sup ported housing, industrial and business parks, small business incubators , and shopping centers. They finance franchises and joint ventures, and provide small, micro and medium size loans and venture capital to businesses that cannot secure conventional capital. They are responding to worker dislocation resulting from defense cutbacks, and the need to create new jobs through economic conversion, business diversification, and investment in new technologies. They are comprehensive in their strategies, knowledgeable about their communities, create, new income and assets for residents, and leverage funds with the economic mainstream. CDCs are nontraditional financial intermediaries. They work in partnership with the public sector-Federal, State and local government-and the private sectorfoundations, banks, private business-to attract investment and lending capital to low- and moderate-income communities. According to our recent research studies, between 1985 and 1990 alone, 1,160 CDCs across the U.S.: -built or rehabilitated 320,000 units of low income housing -developed over 17.4 million square feet of commercial /industrial real estate -made 3,500 business loans -created or sustained over 90,000 jobs. CEI Profile Now let me briefly describe CEI as a model, rural community development corporation. Maine's is a small business economy, with 90 percent of the businesses employing fewer than 20. It also has a high rate of self-employment. Yet Maine has traditionally been at the end of the capital pipeline, ranking among the lowest nationally in bank deposits per capita. CEI was organized in 1977 to address the capital needs of small businesses and communities, and to create income, employment and ownership opportunities for low-income people. CEI is a private and publicly funded CDC. We provide financing and technical assistance in development of job-creating, value-added, natural resource industries, export marketing companies, start-up and expanding small manufacturers, microenterprises, women in business, family and center-based child care, and affordable housing. We have loaned or invested $20 million, leveraged $60 million in partnership with banks, and created or sustained some 3,500 jobs. We are an SBA 504 certified lender, and operate the SBA's microloan demonstration, and the FmHA's Intermediary Relending Program. We participate in private foundation Program Related Investments, such as with the Ford Foundation. We are also a certified borrower with the Finance Authority of Maine. We employ 24 people. We are a membership organization, with a 15-member board representative of business, banking, community organizations and the public sector. Examples of CEI Projects What are some examples of CEI projects. We have a growing portfolio financed on the continuum of capital need, from less than $5,000 to over $ 300,000 (please refer to the attached chart on CEI funds). Our smallest loan is less than $700 to Sweet Deceptions in Lewiston, a self-employed starting microentrepreneur producer of sugar- free sweets and baked goods with only a few thousand in sales; our largest, over $400,000 in subordinated debt loan and equity investment to a producer of advanced technology geographic and recreational maps with over 100 employees and sales above $ 10 million. Examples of our economic development impact are: -sectorial financing of the natural resource industries, such as the fisheries benefiting over 800 fishermen, crew and employees; -investment in 70 start-up and expanding small business manufacturing operations employing 1,500 ; -loans to 200 small, self-employed and microenterprises representing a range of producer, retail and service businesses; -development of 50 family and center-based child care operations for over 1,600 pre-schoolers, and 200 jobs for providers; -business counseling in planning, marketing, and technical assistance in $10 million of financing for over 4,000 small businesses that employ as many as 10,000 99 people, including women in business, refugees, dislocated workers, unemployed professionals, and AFDC recipients. Filling the Credit Gap What role does CEI play in filling the credit gap? We are a nontraditional financial intermediary, and integrate this role with community development, technical assistance and market research programs. Financing is the last step in the process development process. We are the community development bank without the bank, working in partnership with Maine banks to provide guarantees, subordinated debt and equity capital for the very small, self-employed micro enterprises, to more sophisticated businesses. We make the deal happen by filling the credit gap. As you know well, the banding industry has undergone significant changes in the last five years that have impacted the availability of credit. In many cases, risk assessment of loans have resulted in the application of more stringent criteria. Even small businesses with long-standing credit histories have seen their relationships with banks strained. These trends have increased the need for alternative sources of commercial credit. CDCs offer flexible, individualized credit attention, and leverage additional loan dollars from banks. Let me illustrate for you how our funds-flexible, subordinated debt or equity capital-function in the financial structure of a business, over and over again, no matter how small, or how big, to ensure more conventional credit sources are accessed, and that the project has a chance to start up or expand. Example of Gap Financing During the Presidential election campaign, Senator Gore visited Moulded Fibre, Inc. in Westbrook. His purpose was to demonstrate the relationship between job creation and environmental sensitivity. Moulded Fibre processes recycled newspapers into a packaging fibre substitute for environmentally destructive styrofoam. But Moulded Fibre, which now employees 44-and I might add they have hired AFDC recipients, dislocated workers and people with disabilities-was a start-up. To finance the nearly $ 1.1 million project, $375,000 in equity and subordinated debt was needed. CEI and other investors provided this financing. The SBA 504 program came next with a $325,000 debenture, and only then could the bank provide the balance of $400,000. Recommendations And now, let me close with some recommendations that could ensure a successful Community Revitalization System. 1. Provide funding for qualified existing and emerging nonprofit, community-based development organizations using any one of four models listed below: a) community development banks and credit unions b) partnerships with banks c) small-scale, community-based venture capital d) micro and community loan programs These approaches will allow organizations to test strategies to build on CRA to accelerate targeted investment. Partnerships with banks will ensure their participation in the Community Revitalization System. 2. Consider special assistance to nonprofits to form a community development bank, or acquire a troubled bank. 3. Provide technical assistance and planning grants to enable community organizations to analyze their market and develop a business plan for forming a community development bank or partnership. 4. Provide first-year funding for the Community Revitalization System adequate to support 100 projects for community development banking and credit unions, partnerships with banks, micro and community loan funds, planning, technical assistance, and evaluation. Conclusion A Community Revitalization System will create jobs, income and ownership opportunities, reinforce CRA and leverage private capital to economic sectors, regions and populations in need of help. There is a tested, experienced and dedicated network of community development practitioners prepared to renew and expand their roles in development of distressed urban neighborhoods and rural regions . On their behalf, I urge your support for legislation that would enhance and build on the current community development system, community development banks , community credit unions and loan funds, and the 25-year finance development legacy and expertise of community development corporations. 100 Neal Peirce, syndicated columnist, and writer Carol Steinbach, in their 1990 Enterprising Communities stated that the thought of the community development movement failing is unthinkable. They said: "In an age of social fragmentation and indifferent bureaucracies, the movement promises a personalized, neighborhood-based renewal for the most disadvantaged Americans . community development corporations are not just a minor local phenomenon. They are an absolute national necessity." Thank you, and I would be glad to answer any questions or provide additional information. on 20 Family Care Day TWETO EVER DIMONOS Women's Business Housing $.84 Fund Refugee ,Rental & Ownership Cooperative Small Self/ Employment Enterprise Supported Housing SelfAFDC Employment oparons venture mil 5 $ *A in is fund planning the stage Social Services Enterprise Fund pourts Natural Resources $8 Development Fund $19.14 231 101230 000 Small Medium Business 1$.2 Venturo Fund Capital SBA 504 6$.1 91263 Hlapna 20 J STY Cynay ATERNA ECOLONICDEA Fund Investment Targeted Sectors )a millions Capitalization (innd 9475 INVESTMENT Grehodon TYDEV CORP. SORHOOD LOPMENT HECTIC all 32 ty.com N FEDERA LITATE CTEBE VMD Total Loan and UC DEA -1991 CEI FUNDS FINANCE DEVELOPMENT SBA -EMicro Self mplymt 101 101 UKTE JAOAS R3991221 2201 102 NCCED Organizational Members City Anchorage, Anchorage, Anniston , Tuscaloosa , St. University , Tuoson, Forrest City , Pine Bluff, Phoenix, Chinle, San Francisco, San Francisco, Saticoy , Berkeley, San Francisco, Salinas, Santa Monica, East Palo Alto, Los Angeles, Oakland, Los Angeles, Richmond, San Jose , Huntington Park, Oakland , Los Angeles , Los Angeles, Los Angeles, San Francisco, El Monte, Berkeley , Oakland , Los Angeles, Los Angeles, Santa Cruz, Hayward, Los Angeles, Long Beach, Los Angeles, Los Angeles , Monrovia, Sydney, Nova Sootia Nova Scotia Sydney, Nova Scotia Denver, State AK AK AL AL AR AR AR AR AZ AZ CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CN CN CN 82222 Organization COMMUNITY ENTERPRISE DEV. CEDC of Alaska CAA OF CALHOUN , CLEBURNE AND COMMUNITY SERVICE PROGRAMS CENTER FOR ECONOMIC DEV. PORTABLE PRACTICAL EDUCATIONAL SCF-MISSISSIPPI RIVER THE GOOD FAITH FUND CHICANOS POR LA CAUSA DINEH COOPERATIVES ASIAN NEIGHBORHOOD DESIGN BANK OF AMERICA CABRILLO ECONOMIC DEY. CORP. CALIFORNIA CEDA CHINESE COMMUNITY HOUSING CORP. CHISPA COMMUNITY CORP . OF SANTA MONICA COMMUNITY DEV. INSTITUTE DREW ECONOMIC DEVELOPMENT CORP. EAST BAY ASIAN LOCAL EL CENTRO HUMAN SERVICES CORP. GREATER RICHMOND CDC HOUSING FOR INDEPENDENT HUB CITIES CONSORTIUM KOREAN COMMUNITY CENTER KOREAN YOUTH CENTER LOS ANGELES COMMUNITY LOS ANGELES URBAN LEAGUE MISSION ECONOMIC DEY. NATIONAL CENTER FOR AMERICAN NATIONAL ECON. DEV. NEIGHBORHOOD HOUSING SERVICES NEW ECONOMICS FOR WOMEN PACIFIC ASIAN CONSORTIUM SANTA CRUZ COMMUNITY SPECTRUM COMMUNITY SERVICES TEL ACU UNITED CAMBODIAN COMMUNITY, INC VERMONT-SLAUSON ECON . WARD ECONOMIC DEVELOPMENT CORP . WORLD VISION CENTRE FOR COMMUNITY COLCHESTER /TRURO /STEWIACKE REDTF NEW DAWN ENTERPRISES , LTD. ASSOCIATED NETWORK OF MINISTRIES 103 State CO CO CO DC DC DC DC DC DC DC FL FL FL FL FL FL FL FL FL FL ៥ ៥៩៩ ៨ City Denver, Denver, Denver Denver, Bridgeport, Hartford, Danielson , New Haven, Yestport, Washington, Washington, Washington, Washington, Washington, Washington, Washington, Miami, Jacksonville, Pensacola, Miami, Quincy , Miami, Hallandale, Miami, Miami Beach, Miami, Mhami, Belle Glade, Miami, Miami, Jacksonville, Decatur, Valdosta, Honolulu, Chicago, Chicago, Chicago, Kankakee, Chicago, Chicago, Chicago, Chioago, Chicago , Chicago, Chicago, 188885566688888882ZZ Organization DENVER COMMUNITY DEY. CORP. HOPE COMMUNITIES, INC. NEIGHBORHOOD REINVESTMENT CORP. NEWSED COMMUNITY DEV . CORP. BRIDGEPORT NEIGHBORHOOD BROAD PARK DEVELOPMENT CORP. NORTHEASTERN CONNECTICUT CDC , INC. NUTMEG HOUSING DEV. CORP . SAVE THE CHILDREN FEDERATION ACTION TO REHABILITATE CORPORATION FOR ENTERPRISE DEV. H STREET COMMUNITY DEV. CORP. MANNA, INC. MARSHALL HEIGHTS COMMUNITY NATIONAL COOPERATIVE BANK UNIVERSITY LEGAL SERVICES CODEC, INC. COMMUNITY ECONOMIC DEV. COUNCIL COMMUNITY EQUITY INVESTMENTS , INC. DADE EMPLOYMENT AND ECON. FLORIDA FEDERATION OF CDCs Greater Miami United HALL AND ALE COMMUNITY DEV . CORP. METRO-DADE COMMUNITY & MIAMI BEACH DEVELOPMENT CORP. MIAMI-DADE NHS NEW CENTURY DEVELOPMENT CORP. NOAH DEVELOPMENT CORPORATION TACOLCY ECONOMIC DEV . CORP. WEST PERRINE CDC First Union National DEKALB COUNTY ECON. OPPORTUNITY QUITMAN/BROOKS COUNTY CDC ALU LIKE, INC. AMOCO CORPORATION BETHEL NEW LIFE CHICAGO ASSOCIATION OF CITY OF KANKAKEE CLARENCE-DARROW COMMUNITY COMMUNITY ECON. DEV. ASSOC. COMMUNITY WORKSHOP ON JANE ADDAMS RESOURCE CENTER LAWRENCE AVENUE DEV. CORP. SHOREBANK ADVISORY SERVICES , INC. THE NEIGHBORHOOD INSTITUTE FL FL FL GA GA HI L L L IL IL L L 104 Organization BUSINESS OPPORTUNITIES SYSTEMS EASTSIDE COMMUNITY INVESTMENTS, INC. HISTORIC LANDMARKS FOUNDATION HOOSIER UPLANDS ECONOMIC INB NEIGHBORHOOD INDIANA ASSOCIATION FOR CED INDIANA CAP DIRECTORS' ASSOC. , INC. INDIANAPOLIS NEIGHBORHOOD INTERFAITH HOMES, INC. LINCOLN HILLS DEVELOPMENT CORP. MARTIN LUTHER KING CDC NEAR NORTH DEVELOPMENT CORP. RILEY AREA REVITALIZATION WESTSIDE COMMUNITY DEVELOPMENT COMMUNITY VENTURES CORPORATION KENTUCKY HIGHLANDS INVESTMENT CORP . MOUNTAIN ASSOCIATION FOR CED , INC. NEW DIRECTIONS HOUSING CORP. CORPORATION FOR NEW DESIRE COMMUNITY HOUSING SOUTHERN COOPERATIVE DEY. FUND CHINESE ECONOMIC DEV . COUNCIL CODMAN SQUARE HOUSING COMMUNITY DEV . CORP . OF BOSTON COMMUNITY DEV. CORP. COMMUNITY ECONOMIC DEV DORCHESTER BAY EDC EAST BOSTON COMMUNITY FENWAY CDC FIELDS CORNER CDC ICA REVOLVING LOAN FUND INQUILINOS BORICUAS LENA PARK CDC MADISON PARK DEVELOPMENT CORP MASSACHUSETTS ASSOCIATION OF CDCs MASSACHUSETTS COMMUNITY DEV. NEIGHBORHOOD OF AFFORDABLE HOUSING NUESTRA COMUNIDAD DEV. CORP . QUINCY-GENEVA HOUSING CORP . THE SOMERVILLE CORFORATION URBAN EDGE HOUSING CORP . YOUTH ACTION PROGRAM ANNE ARUNDEL COUNTY COMMUNITY ASSISTANCE NETWORK DEVELOPMENT TRAINING INSTITUTE City Indianapolis, Indianapolis, Indianapolis, Mitchell, Indianapolis, Indianapolis, Indianapolis, Indianapolis, Indianapolis , TellCity , Indianapolis, Indianapolis , Indianapolis, Indianapolis, Lexington , London, Berea, Louisville, Natchitoches, New Orleans, Lafayette, Boston, Dorchester , Boston , Fitchburg, Boston, Dorchester , East Boston, Boston, Dorchester, Somerville, Boston, Dorchester , Roxbury , Boston , Boston, East Boston, Roxbury , Roxbury , Somerville, Jamaica Plain, Belmont, Annapolis , Baltimore, Baltimore, State IN IN IN IN IN IN W IN N IN IN IN IN IN KY KY KY KY LA LA LA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MA MD MD MD 105 City Columbia , Salisbury , Baltimore, Wiscasset, So. Paris, Pontiao, Caro, Lansing, Lansing, Pontiao, Detroit, Ecorse, Detroit Lakes, Minneapolis, Saint Paul, St. Louis , Kansas City, Kansas City , Kansas City , St. Louis, Greenville, Bozeman, Durham , Raleigh, Henderson , Durham, Hendersonville, Durham , Research Triangle Park, Raleigh, Durham, Chapel Hill, Raleigh, Charlotte, Rocky Mount, Raleigh, Durham, Wilson , Omaha , Manchester, Newark, Trenton, Albuquerque, Embudo , Belmont, 2332 Ürganization ENTERPRISE FOUNDATION SHORE UP INC .! SOUTHEAST COMMUNITY COASTAL ENTERPRISES, INC. COMMUNITY CONCEPTS, INC. CITIZENS COALITION FEDERAL HUMAN DEVELOPMENT COMMISSION MICHIGAN COMMUNITY ECON. MICHIGAN STATE UNIVERSITY OAKLAND LIVINGSTON HUMAN WARREN/CONNER DEVELOPMENT WAYNE-METROPOLITAN COMMUNITY MIDYEST MINNESOTA COMMUNITY MINNESOTA CENTER FOR CED TWIN CITIES HOUSING ANHEUSER-BUSCH COMPANIES , INC. BLACK ECONOMIC UNION CDC OF KANSAS CITY CITIZEN HOUSING INFORMATION NORTHSIDE RESIDENTIAL HOUSING DELTA FOUNDATION HUMAN RESOURCE DEV . COUNCIL CENTER FOR COMMUNITY SELF-HELP DIVISION OF COMMUNITY GATEWAY CDC HAYTI DEVELOPMENT CORPORATION HOUSING ASSISTANCE CORPORATION LAND LOSS PREVENTION PROJECT NORTH CAROLINA ALTERNATIVE NORTH CAROLINA ASSOCIATION NORTH CAROLINA COALITION OF N.C. REAL ENTERPRISES, INC. NORTH CAROLINA RURAL CENTER REID PARK NEIGHBORHOOD ROCKY MOUNT/EDGECOMBE CDC SOUTHEAST RALEIGH CDC UDI COMMUNITY DEY. CORP. WILSON COMMUNITY IMPROVEMENT OMAHA ECONOMIC DEV. CORP. NEW HAMPSHIRE COLLEGE NEW COMMUNITY CORPORATION NON-PROFIT AFFORDABLE HOUSING HOME EDUCATION LIVELIHOOD PROGRAM SIETE DEL NORTE CDC ACCORD CORPORATION State MD MD ME MI MI MI MI MN MN MO MO мо MO MO MS MT NC NC NC NC NC NC NC NC NC NC NC NC NC NC NC NC NE NH NJ NJ NM NM NY 106 Cita Bronx, New York, New York, New York , Malone, Yonkers, • Elizabethtown, Ithaca, New York, Brooklyn, Nanuet, Pearl River, Rochester, New York, Bronx, Elmira, Bath , Troy, Rochester, Indian Lake, Rochester, Canton, Cincinnati, Cleveland, Toledo, Cleveland, Cleveland , Cleveland , Cincinnati, Columbus, Cincinnati, Cincinnati, Cleveland, Cincinnati, Toledo , Columbus , Lima, Dayton, Columbus, Cincinnati , Fremont, Dayton, Portland, Milwaukie, Portland, State NY NY NY NY NY NY NY NY NY NY NY NY NY NY NY NY NY NY NY NY NY OH OH OH OH OH OH OH OH OH OH OH OH OH OH OH OH OH OH OH OH OH OR OR OR ន Organization BRONX VENTURE CORPORATION CITICORP /CITIBANK CED LEGAL ASSISTANCE CENTER COUNCIL FOR COMMUNITY-BASED DEV. FRANKLIN COUNTY COMMUNITY GREYSTON FOUNDATION HOUSING ASSISTANCE PROGRAM ITHACA NEIGHBORHOOD HOUSING LOCAL INITIATIVES SUPPORT CORP. PRATT INSTITUTE CENTER ROCKLAND COMMUNITY ACTION ROCKLAND ECONOMIC DEV . CORP. RURAL OPPORTUNITIES, INC. SETTLEMENT HOUSING FUND, INC . SOUTH BRONX OVERALL ECON. SOUTHERN TIER OFF. OF SOC. MIN. STEUBEN CHURCHPEOPLE AGAINST TROY REHABILITATION & URBAN LEAGUE OF ROCHESTER , WARREN-HAMILTON HOUSING CORP. Rural Opportunities, Inc. ASSOC. FOR A BETTER COMMUNITY AVONDALE REDEVELOPMENT CORP. CENTER FOR NEIGHBORHOOD DEV. CITY OF TOLEDO CLARK-METRO DEVELOPMENT CORP. CLEVEL AND NEIGHBORHOOD DEV. CORP. COLLINWOOD COMMUNITY SERVICE DEY. CORP. FOR CINCINNATI FRIENDS OF THE HOMELESS JOBS FOR PEOPLE LOWER PRICE HILL CURC NATIONAL CITY CDC NDC ASSOCIATION OF NORTHRIVER DEVELOPMENT CORP. OHIO CDC ASSOCIATION REHAB PROJECT SRD-NEIGHBORHOOD DEVELOPMENT STATE OF OHIO CDFF WALNUT HILLS REDEVELOPMENT YSOS COMMUNITY ACTION SRD-Neighborhood Development NORTHEAST COMMUNITY DEV. CORP. NORTHWEST HOUSING OREGON COUNCIL FOR 107 Organization REACH COMMUNITY DEVELOPMENT SOUTHEAST UPLIFT ALLIED HUMAN SERVICES BUREAU OF HUMAN RESOURCES CENTRAL PENNSYLVANIA COMMUNITY COMMUNITY HUMAN SERVICES CORP. COMMUNITY TECHNICAL ASSISTANCE DUQUESNE BUSINESS ADVISORY EAST OF BROAD COMMUNITY HISPANIC ASSOCIATION OF HOMEWOOD-BRUSHTON REVITALIZATION MANCHESTER CITIZENS CORPORATION MAYOR'S OFFICE OF COMMUNITY NORTH SIDE CIVIC DEV. PENNSYLVANIA DIRECTORS ASSN. PENNSYLVANIA FARMWORKER PHILADELPHIA COMMUNITY ECONOMIC DEVELOPMENT CORPORATION JUBILEE INNER CITY DEVELOPMENT CORP. OIC OF RHODE ISLAND YAHID COOPERATIVE ENTERPRISES, INC. Cita Portland, Portland, New Castle, Harrisburg, Clearfield, Pittsburgh, Pittsburgh , Duquesne, Philadelphia, Philadelphia, Pittsburgh , Pittsburgh, Philadelphia, Pittsburgh, Harrisburg, Camp Hill, Philadelphia, San Juan, Providence, Providence, Newport, NORTHEAST SOUTH DAKOTA ECC SISSETON-WAHPETON SCHOOL BOARD THE LAKOTA FUND CHATTANOOGA NEIGHBORHOOD EAST TENNESSEE COMMUNITY FISK AREA DEVELOPMENT CORP. M. L.KING BOULEYARD CDC MATRIX, INC. TENCO DEVELOPMENTS, INC. TENNESSEE NETWORK FOR CED WEST GREENVILLE CDC AVENIDA GUADALUPE ASSOCIATION EAST AUSTIN ECONOMIC FREEDMEN'S TOWN ASSOCIATION , INC. QUIN RIVERS AGENCY FOR RICHMOND BETTER HOUSING SOUTHWEST VIRGINIA COMMUNITY TASK FORCE FOR HISTORIC PRESERVATION VIRGINIA WATER PROJECT TRI-ISL AND ECONOMIC DEV . COUNCIL Sisseton, Agency Village, Kyle, Chattanooga, Knoxville, Nashville, Chattanooga, Knoxville, Lewisburg, Knoxville, Greenville, San Antonio, Austin, Houston, Providence Forge, Richmond, Roanoke, Richmond, Roanoke , St. Thomas, TX TX TX YA VA VA VA የለ VI NORTHERN COMMUNITY INVESTMENT CORP. TOWN OF ROCKINGHAM St. Johnsbury , Bellows Falls, VT VT State OR OR PA PA PA PA PA PA PA PA PA PA PA PA PA PA PA PR 888EEEE === X E * RI RI TN TN TN TN TN 55 108 Organization BENTON-FRANKLIN COMMUNITY COLUMBIA BASIN MINORITY EL CENTRO DE LA RAZA GRANT COUNTY COMMUNITY ACTION PIC OF SNOHOMISH COUNTY PLYMOUTH HOUSING GROUP THE OPPORTUNITY COUNCIL UPPER TACOMA RENAISSANCE WASHINGTON ASSOCIATION FOR CED Cita Pasco, Pasco, Seattle, Moses Lake, Everett, Seattle, Bellingham , Doma , ADVOCAP , INC. CAP SERVICES, INC. CENTRAL WISCONSIN CAC, INC. COMMON WEALTH DEVELOPMENT , INC. COMMUNITY RELATIONS-SOCIAL COOPERATIVE WEST SIDE ASSOCIATION DANE COUNTY COMMUNITY IMPACT SEVEN , INC. INNER CITY REDEVELOPMENT CORP. LA RAZA UNIDA , INC. NEWCAP, INC. NORTHWEST SIDE CDC WEST CENTRAL WISCONSIN CAA, INC. WESTERN DAIRYLAND E.0.C. WISCONSIN COULEE CAP MATEWAN DEVELOPMENT CENTER TELAMON CORPORATION Fond du Lac, Stevens Point, Lake Delton, Madison, Milwaukee, Milwaukee, Madison, Turtle Lake, Milwaukee, Fort Atkinson, Oconto, Milwaukee, Glenwood City , Independence, Westby , Matewan, Martinsburg, State YA WK 3 1 YA 2 M WI 5 C 109 STATEMENT OF ROBERT JACKSON, TREASURER, QUITMAN COUNTY FEDERAL CRÉDIT UNION Mr. Chairman, members ofthe Committee, I am Robert Jackson, Treasurer ofthe Quitman County Federal Credit Union. We are located in Marks, Mississippi, a lowincome rural community in the Mississippi Delta about 80 miles south of Memphis. I also serve on the Board of Directors of the National Federation of Community Development Credit Unions, a coalition of credit unions that serve low- and moderateincome communities throughout the United States. The Federation is affiliated with the Credit Union National Association, the national trade organization for credit unions. Speaking for my small credit union and for the larger credit union movement, I would like to express strong support for the new administration's initiative for expanded community development financial institution activity. The story I have to tell you about the situation in the Mississippi delta will show very clearly just how urgent our needs are. Community Development Credit Unions Before talking about the particular experiences of my credit union, I would like to say a few words about the national community development credit union movement. Of the 14,000 or so credit unions in the United States, more than 300 serve low-income communities in rural communities, inner-city neighborhoods and Indian reservations. The primary mission ofthese institutions is to provide credit and other financial services to people who are considered "unbankable" by mainstream financial institutions. The need for credit in these areas is desperate. One CDCU in central Florida makes loans to migrant farm workers who need second-hand trucks in order to commute to work in surrounding counties. Another CDCU in San Francisco has made small loans that allow newly-arriving Vietnamese immigrants to continue earning a living as fishermen. A Harlem CDČU once lent funds to an entrepreneur who wanted to expand his auto repair business but had been turned down by 10 different banks. In this case, the borrower repaid his credit union loan three years early. In central Appalachia, a CDCU works with public assistance recipients who want to start their own businesses and get off welfare. This group's efforts were recently described in a front-page Wall Street Journal article. Hispanic and Haitian migrant farm workers, Vietnamese immigrants, small business owners in Harlem and welfare mothers in Appalachia are not the kind of lucrative clients that other institutions are looking to serve. Frankly, in my opinion, many institutions don't even want these folks coming in the front door because they can't make a profit serving this kind of clientele. The Story of Quitman County In Quitman County, our credit union was formed 11 years ago in order to cope with a lack of access to credit. Like so many other places in the Mississippi delta, Quitman County is a place where African-American residents are mired in poverty and trying to cope with the legacy of centuries of economic and political discrimination. My town, Marks, was one of the key sites of civil rights activity that was visited by Dr. Martin Luther King, Jr. which was highlighted in newspaper publications across the country on Sunday, January 17, 1993. To this day, however, there is persistent rural poverty. Unemployment in the area is 18 to 20 percent in the African-American community and 9.8 percent overall . The per capita income in the county is $6,450 annually. The per capita income for African-Americans is $4,133. Many African-Americans are living in substandard housing without running water. They would like to buy new homes or repair the old ones, and they would like to start a small business or borrow money to send a child to school. Until 1977, there was only one bank in the Marks area and it was owned by a local family that also controlled much of the land and political machinery in the county. Since loans were routinely denied, many poor people, including my parents who were sharecroppers, didn't even bother to go to the local bank. Out of pure desperation, we organized a grass-roots movement for equality that led to the creation of the Quitman County Development Organization and the Quitman County Federal Credit Union. The credit union has $1,017,000 in assets and serves 850 members and growing. Since the day we were organized, we have lent more than $2,126,000 to local people, most of whom would not have any other access to credit. I would like to tell you the story of a typical loan that we make to a family that has stayed on the farm or plantation all their lives up until 1989. The father got sick and couldn't work on the farm anymore, and was asked to move out of the plantation owned house. The family had nowhere to move, no credit history to assume a mortgage, and no breadwinner for the family. The family approached the credit 110 union for a housing loan to purchase a $ 10,000 house. The credit union made the loan because we knew the family. I'm happy to say that they have made their monthly payment like clockwork. An article on CDCU's in Credit Union Magazine, October 1990 issue, tells of this story in more detail. A copy of this article is attached. What would have happened to this family? I'm afraid to think what may have transpired if the credit union had not been there. This is not an exception, this is the rule. Families being displaced from large plantations with nowhere to go, and no money to move anywhere else. No sympathy from the landowners, and no severance pay, no retirement, nothing. I believe that CDCU's are financial institutions with a conscience . And we need more of them. While we have been successful in providing credit to people who would otherwise be shut out of the capital market, there is a great deal more that we would like to do. We are particularly interested in duplicating the successes of the Nation's largest CDCU, the Self-Help Credit Union of North Carolina. Self-Help has more than $40 million in assets and has extended loans throughout the State of North Carolina. This success is due in large part to an innovative structure that combines the credit union and a non-profit development organization. Working together the two institutions can provide a full spectrum of services needed to further economic development. We have the same structure in Quitman County. Our credit union provides credit and savings services, while the non-profit, Quitman County Development Organization is able to conduct fundraising and take on larger and higher risk development projects. All this is done in coordination with each other and other non-profits in the area. I am confident that we can grow to Self-Help's size and scope in a safe and sound manner. But that will require relief from current regulations imposed on us by our regulatory agency, the National Credit Union Administration (NCUA) . We also need more technical assistance from them and a strategic investment of Federal resources. In talking about public investment in CDCUs, an important ratio to keep in mind is 10 to 1. For every dollar that a CDCU receives in reserve funds, the institution is able to extend 10 dollars in loans for home acquisitions and repairs, small business development and other purposes. If my credit union had a $ 100,000 infusion of equity, I can guarantee you that we will make $ 1 million dollars worth of loans in Quitman County, Mississippi, the poorest section of the United States. As a county supervisor (commissioner), I understand your budgetary concerns. I also understand the power that you have as a Federal lawmaker to change policy from the top. As you go about the process of creating a community development banking program, and I'm confident you will, there are a few positive steps that you can take to help credit unions like mine and others throughout the United States. I support the following recommendations of the National Federation of Community Development Credit Unions for steps which Congress can take to improve access to credit for consumers and small businesses. • Through Community Development Banking legislation, provide equity infusions to CDCUs and other community development lenders. This is the single most important step that Congress can take. Despite all the good work that CDCUs are doing, our impact has been limited by our small size. Most CDCUs and other community development lenders will need to be bigger institutions in order to have a meaningful impact on the credit crisis. By providing equity capital to community development lenders, you allow them to expand and sustain their work, which might otherwise be discouraged as "high risk" by regulators. • Recognize and establish that lending for small and micro-businesses is a valid and valued function of credit unions , especially in low-income and other underserved areas. This would mean, among other things, preserving the tax exemption on credit unions and getting the National Credit Union Administration to ease current regulatory restrictions on business lending. We have seen significant improvement in the treatment of CDCUS by our regulators during the last year. We would like to see legislative action that will enhance, reinforce, and institutionalize those improvements. • Facilitate access to existing secondary markets, and create, if necessary, a specialized secondary market for community development loans. • Provide funding for technical assistance to new and growing community development lenders. • Keep CRA in place. The Community Reinvestment Act (CRA) has been a very important part of our success in the last decade ; many of our CDCUs have received financial support-including equity and operating grants, and interest-free deposits-from banks as a direct or indirect result of CRA. While we believe that banks that support community development lenders like CDCUs should get CRA credit, 111 we do not want to see CRA weakened. It is an invaluable tool for producing productive partnerships in many low-income communities. • Increase the level of funding for the Revolving Loan Program for CDCUs operated by the National Credit Union Administration. At present, the program has $6 million to invest among hundreds of CDCUs nationwide. An increase in the program will enable more institutions to be served. In closing let me again emphasize the importance of easing the current regulatory restraints under which we labor. To effectively do our job, we must never be held back by limits on non-member deposits and we must have additional flexibility in making small business loans to our members. Attached is a CUNA position paper on these issues with amendments which I support. This concludes my statement. I will be glad to answer any questions. POSITION PAPER-COMMUNITY DEVELOPMENT BANKING The Credit Union National Association and Affiliates (CUNA) fully supports the concept proposed by the Clinton Administration to expand the role of community development banking. This paper is to share some of our preliminary ideas and recommendations concerning this important and potentially far-reaching initiative. CUNA is the primary trade association representing this country's 13,400 credit unions and their 65 million members. One of its affiliates is the National Federation of Community Development Credit Unions. The credit union movement continues to exist separately from the banking system of this country for very basic reasons: ( 1) it can still demonstrate its unique and different approach to providing consumer financial services; and (2) this unique approach continues to bring substantial benefits to consumers that are worth preserving. Some people are able to get a loan at a credit union when they were unable to find credit elsewhere. CUNA is committed to preserving this credit union philosophy. Certainly the work done by low income, or community development credit unions, exemplifies the credit union difference. We welcome this renewed interest in providing credit at reasonable rates to those who have been left out of the traditional financial system and especially in providing small business loans to assist in the rehabilitation of low income areas. It is easier, even within the credit union community, to concentrate on the more routine extensions of credit and to lose momentum in the seeking of new avenues to reach those with limited access to credit. This tendency has been exacerbated by changes to the legislative and regulatory atmosphere which have occurred over the past several years. For instance, the National Credit Union Administration (NCUA) and its predecessor, the Bureau of Federal Credit Unions, once placed a high priority on the actual promoting of credit unions and the credit union movement. Awards were given to examiners who had chartered the most credit unions or contacted the most groups informing them about credit unions, technical assistance was given to struggling credit unions, and it was recognized and acknowledged that many differences would exist among credit unions depending on their missions and the agency adjusted itself to accommodate for these differences. However, circumstances occurred which greatly influenced this agency's perspective. As a result of the savings and loan crisis and the large number of bank failures, the Congress sent strong legislative signals to all financial regulators to vastly increase their supervisory activities. Advocacy roles by regulators came under criticism. This coupled with tremendous growth in the credit union movement and the advent of Federal share insurance for credit unions led the agency to begin operating from a new set of priorities. It retreated from its advocacy role and centered its efforts on eliminating any and all perceived threats to the National Credit Union Share Insurance Fund (NCUSIF). While a healthy concern for safety and soundness is an essential component of the credit union movement, it is not its primary purpose or "raison d'étre." Regulatory pressures have ensued which seek more standardized credit unions and credit union lending. Non-traditional lending activities are often viewed as potential threats to the insurance fund. Unnecessary restrictions have been placed on the amount of non-member deposits which community development credit unions can seek. New charters, especially community development ones, had become extremely cumbersome and rare. Restrictions on small business loans to credit union members are excessive. Merger and liquidation actions have become so commonplace they scarcely raise an eyebrow. What was formerly resorted to as a last resort is often used now as a supervisory tool to improve the overall safety and soundness scorecard of the credit union movement or to facilitate the movement toward fewer and more standardized credit unions. Because of the virtual elimination of new charters and the ex- 112 tremely high merger and liquidation activities, the number of credit unions in this country has gone from a high of 22,200 in 1978 to today's figure of 13,400. In general, the emphasis has shifted from assisting credit unions to carry out their chosen missions in a safe and sound manner to an over emphasis on safety and soundness at the expense of individual missions. For example, some community development credit unions in existence for a number of years have been liquidated because their measured financial condition was marginal and it was determined that they "would never succeed. " This view of what constitutes success is too narrow and fails to see that in terms of struggling to bring hope and change to individuals lacking access to credit and financial services, the credit unions were already demonstrable successes. It is unfortunate that many of these credit unions are no longer in existence. Further, the combined assets of these credit unions is so relatively small as to make any potential insurance losses very limited. Some would argue that these changes have produced a credit union movement that is more efficient, more standardized, more streamlined, and easier to control and supervise. While these observations are true, that is not necessarily the best public policy. Public policy is best served by a secure financial system that provides opportunity to those of modest means, not simply one that lends itself to efficient regulation. Tens of thousands of credit union volunteers have been eliminated along with their ideas and service at the local level; decision-making has become more centralized and thusly more standardized; communities and groups have lost the closeness and sense of ownership control which their own credit union brought to them; and diversity and uniqueness have been reduced. Therefore we are pleased that the focus is now on the promotion of imaginative, case-by-case initiatives where individual financial institutions seek to best meet the particular needs of their locales (and their members), rather than seeking standardized methods of delivering only those types of services which have a proven track record . Hearings such as these and the use of a new Government entity such as a National Trust for Community Development Financial Institutions should afford the necessary impetus and advocacy to fully embrace this important objective of reaching out to those communities which are in the greatest need. Under this new plan, we assume that NCUA would continue to charter, insure, and regulate and that the National Trust would designate those credit unions eligible for loans, capital infusions, technical assistance etc. and make decisions on the dollar amounts to be awarded to each institution . These two forces should provide a more balanced approach to the goals of extending credit union services and maintaining safety and soundness. We strongly recommend that credit unions be included as an integral component of the Community Development program. The statement of the National Federation of Community Development Credit Unions gives an excellent overview of the positive benefits of CDCUs as well as some specific models that should be replicated in the future. CUNA concurs with the recommendations which have been made by the NFCDCU . Attached are three recommended legislative changes to the Federal Credit Union Act designed to add impetus to credit union participation not only in community development activities but other lending activities which could assist in economic recovery. AMENDMENTS 1. Expediting charters of low income credit unions (includes CDCUs). Amend Section 104 of the Federal Credit Union Act ( 12 USC 1754 ) by adding after the current first sentence, a new sentence which reads : "The Board shall give a high priority to considering the organizational certificate of a low income credit union." Suggested report language: "The Congress intends that the credit union chartering activities be simplified and expedited by NCUA and that special efforts be made in the case of low income credit unions. 2. Small business loans to members. Amend Section 107(5 ) of the Federal Credit Union Act ( 12 USC 1757) by inserting immediately after "(5) to make loans," the following: "including small business loans to their members,". Suggested report language: "The Congress, by specifically including the phrase small business loans to credit union members wishes to signal its recognition that many credit unions serve a membership where their primary focus is not on consumer lending but rather on providing modest size loans for business purposes to their members. NCUA should recognize the needs of such credit unions and pro- 113 vide the necessary flexibility to enable these credit unions to meet the needs of their members ." 3. Non-member deposits. Amend Section 107(6) of the Federal Credit Union Act ( 12 USC 1757) by adding at the end thereof the following new sentence: "In prescribing limitations, the Board shall avoid limitations which preclude credit unions (especially low income credit unions) from providing services to their members." Suggested report language: " The Congress instructs the NCUA to avoid wherever possible the placing of limitations on the receipt of payments (deposits) by credit unions, especially low income credit unions, which would impair the ability of the credit union to successfully carry out its mission." TESTIMONY OF MICHAEL SWACK, CO-DIRECTOR, INSTITUTE FOR COOPERATIVE COMMUNITY DEVELOPMENT COMMUNITY DEVELOPMENT LENDING AND MICROENTERPRISE Microenterprise programs work with entrepreneurial individuals seeking to start or expand small businesses. Microenterprises range from self-employment businesses to businesses employing five people. These businesses usually require small amounts of capital-typically between $250-$ 10,000 in order to operate or expand. Microenterprise programs represent a community-based economic development strategy for business development and job creation among those traditionally left out of the economic mainstream. They provide individuals with the capital and skills they need to turn their businesses or business ideas into reality. The individuals served by microenterprise programs are predominantly women, often people of color, and almost all are welfare recipients, unemployed or the working poor. The creation of small businesses is just one goal of microenterprise programs-they are also designed to increase incomes, stabilize families, raise self-esteem and self-confidence, develop skills, create role models, and spark a process of community renewal. Over 150 microenterprise development programs are represented nationally by the Association for Enterprise Opportunity (AEO) in Chicago. Many microenterprise programs include loan funds or offer financial services through partnerships with local banks or credit unions. Micro loan funds usually are capitalized with grants or loans from foundations or Government agencies. But microenterprises face many barriers. The loan sizes required by microenterprises are typically too small to be considered by traditional financial intermediaries. The cost of transacting such loans is unprofitable for these traditional intermediaries. Additionally, the borrowers are considered to be too “risky”—they do not have much equity to put into the businesses, they have very little collateral, and they do not have histories of running profitable businesses. Although these loans are considered too "risky" by traditional intermediaries, many community-based organizations have successfully loaned to microenterprises. My own organization, the Institute for Cooperative Community Development has run a program called Working Capital for the past two years. During this time we have made over 425 loans in Northern New England. We have utilized a model of lending called "peer" lending, a model utilized extensively overseas in places like Bangladesh and throughout Latin America. In this model, people join borrowing groups . Members start out by borrowing small amounts of money for their businesses. If any member ofthe group fails to repay his or her loan, other members or the group must either make this payment or they will be denied access to further credit. We have enjoyed close to a 97 percent repayment rate over the life of the program. In addition to providing capital, many microenterprise programs provide training, technical assistance and in some cases support services such as child care and transportation to borrowers. The provision of these non-fee generating services, combined with the small loan sizes, means that microenterprise programs are not able to support themselves on fee and interest income. Although it is not within the purview of this committee, it is important to note that microenterprise programs face barriers other than the barrier of access to capital. For microenterprise programs to succeed the Government must eliminate barriers and penalties for transfer payment and public assistance recipients who pursue self-employment. We need to allow AFDC recipients to accumulate business assets and deduct business related expenses in calculating net income; change unemployment insurance laws to exempt recipients from looking for work while starting a business; and, change public housing rent provisions to minimize increases for residents generating wage or self-employment income. 114 Any legislative initiative to create community development financial institutions needs to explicitly recognize and encourage microenterprise lending, whether through microenterprise loan funds or other community-based intermediaries engaged in microenterprise lending. An investment of Federal funds into microenterprise funds could be done in a variety of ways. Our Working Capital program has worked out a unique arrangement with three New England banks (Vermont National Bank, Fleet Bank, and Meredith Village Savings Bank) whereby we have access to bank lines of credit for microenterprise lending. In exchange for access to credit, we establish small loan loss reserve funds at the bank. The small investment into loan loss reserve funds (currently made by foundations) has enabled us to leverage substantial amounts of credit from banks to microenterprises. A legislative initiative that supports investment in microenterprise funds and training and technical assistance to borrowers could greatly enhance the success and growth of microenterprise programs-programs that have already demonstrated success in improving the quality of life for a wide range of people. Finally, as someone who has been an active participant in community investment for 14 years- with a variety of institutions (including microenterprise funds, community development loan funds and quasi -public agencies), I have four specific recommendations for any Government-sponsored financial initiative to promote community-based economic development. 1. A wide range of community development financial institutions ( CDFI), (including commercial banks, community development credit unions, community-development loan funds, microenterprise funds and specialized public agencies) should be eligible to receive investment from a Federal initiative for community development financial institutions. However, any institution receiving investment from a Federal initiative should specify how they will help achieve goals of community development and community investment . Community investment means more than simply investing money in a particular geographic place. A successful program of community investment will stimulate the demand for development capital by supporting the formation of community organizations (like community development corporations and community land trusts), and encouraging these organizations to develop and plan more housing and economic development projects. Organizations I have worked with, such as the Institute for Community Economics and the New Hampshire Community Loan Fund, have helped create new community development organizations, which have in turn created housing and jobs for low-income people. 2. A key need in community development finance is the need for equity investment in low-income communities . A Federal initiative should provide equity to CDFI's and encourage CDFI's to invest equity in community housing and economic development ventures. Traditional loan products are not sufficient to meet community capital needs. My experience as Chairman of the New Hampshire Community Development Finance Authority (CDFA), a quasi-public agency, has demonstrated how critical equity can be to the success of projects. Through equity investments (such as preferred stock and sharing of net operating income), the CDFA can invest the kind of capital that is typically not available to low-income individuals and projects that are developed by organizations serving low-income communities. CDFA's investment improves the capital structure of the venture, leverages private debt, and enhances the probability of success for the venture. 3. Encourage additional private investment in CDFI's by the private sector and State and local government . The New Hampshire Community Development Finance Authority (CDFA) provides an interesting example of how to encourage investment in community development by the private sector. The State provides a tax credit to businesses that commit funds to the CDFA-the CDFA can then use these funds to make equity and debt investments in community-based housing and economic development projects. Federal legislation should include mechanisms that encourage the private sector to invest in CDFI's . 4. A Federal initiative must seek to promote the development of secondary market mechanisms to support the growth and liquidity of CDFI's . One of the primary problems CDFI's face is liquidity. CDFI's originate loans and investments that are nonstandard-that is, they do not fit the standard underwriting criteria of traditional lenders. We hold these loans in our portfolio for several years-during this time many risk factors are reduced. If we could sell these loans in the secondary market, we would have more capital to originate the kinds of loans that only CDFI's originate. Federal legislation should require Government- sponsored entities like Ginnie Mae and Freddie Mac to serve our market. 115 MICHAEL SWACK Michael Swack is a professor and the Director of the Community Economic Development Program at New Hampshire College where he teaches courses in economic development, finance and negotiations. He is also the Co-Director of the affiliated Institute for Cooperative Community Development (ICCD), a nonprofit organization involved in applied research, technical assistance and training. ICCD currently runs the Working Capital program, the largest peer-lending microenterprise program in the United States and the Capital Networks program, a pilot project that provides assistance and credit to businesses participating in flexible manufacturing networks. Mr. Swack has worked in the field of development finance for 14 years as a practitioner, consultant and teacher. He is a trustee and past President of the Institute for Community Economics in Springfield, MA, the Chairman of the New Hampshire Community Development Finance Authority, a founding and current board member of the New Hampshire Community Loan Fund, a founding trustee of the National Association for Community Development Loan Funds and a past member of the Housing Advisory Board for the Federal Home Loan Bank in Boston. He received his doctorate from Columbia University, his masters degree from Harvard University and his bachelors degree from the University of Wisconsin. ADDITIONAL TESTIMONY BY MICHAEL SWACK AND DONALD MASON THE INSTITUTE for Cooperative CommunITY DEVELOPMENT Summary of Priority Issues 1. A wide range of community development financial institutions (CDFI), (including commercial banks, community development credit unions, community development loan funds, microenterprise funds and specialized public agencies) should be eligible to receive investment from a Federal initiative for community development financial institutions. However, any institution receiving investment from a Federal initiative should specify how they will help achieve goals of community development and community investment. Community investment means more than simply investing money in a particular geographic place. A successful program of community investment will stimulate the demand for development capital by supporting the formation of community organizations (like community development corporations and community land trusts), and encouraging these organizations to develop and plan more housing and economic development projects. Organizations I have worked with, such as the Institute for Community Economics and the New Hampshire Community Loan Fund, have helped create new community development organizations, which have in turn created housing and jobs for low-income people. 2. A key need in community development finance is the need for equity investment in low-income communities. A Federal initiative should provide equity to CDFP's and encourage CDFP's to invest equity in community housing and economic development ventures. Traditional loan products are not sufficient to meet community capital needs. My experience as Chairman of the New Hampshire Community Development Finance Authority (CDFA), a quasi-public agency, has demonstrated how critical equity can be to the success of projects. Through equity investments (such as preferred stock and sharing of net operating income), the CDFA can invest the kind of capital that is typically not available to low-income individuals and projects that are developed by organizations serving low-income communities. CDFA's investment improves the capital structure of the venture, leverages private debt, and enhances the probability of success for the venture . 3. Encourage additional private investment in CDFI's by the private sector and State and local government. The New Hampshire Community Development Finance Authority (CDFĂ) provides an interesting example of how to encourage investment in community development by the private sector. The State provides a tax credit to businesses that commit funds to the CDFA-the CDFA can then use these funds to make equity and debt investments in community-based housing and economic development projects. Federal legislation should include mechanisms that encourage the private sector to invest in CDFI's. 4. A Federal initiative must seek to promote the development of secondary market mechanisms to support the growth and liquidity of CDFI's. One of the primary problems CDFI's face is liquidity. CDFI's originate loans and investments that are nonstandard—that is, they do not fit the standard underwriting criteria of traditional lenders. We hold these loans in our portfolio for several years—during this time many risk factors are reduced. If we could sell these loans in the secondary market, we would have more capital to originate the kinds of loans that only CDFI's origi- 116 nate. Federal legislation should require Government-sponsored entities like Ginnie Mae and Freddie Mac to serve our market. I. FEASIBILITY a. To establish a certain specific number of community development financial institutions (CDFI's) to be developed over the next four years is irrelevant. No specific number should be set as a goal, instead, the development process should be allowed to proceed based upon the need, the skill and expertise of those developing the institutions, and the level of capital available for the formation of these institutions. Of course, this process will be determined by the nature of the rules, procedures and policies developed through this legislation . It seems more important to develop a process by which community development financial institutions will be encouraged, rather than set a specific goal . However, any CDFI receiving money from the Federal Government needs to specify how they will measure their own success. b. Community investment means more than simply investing money in a particular geographic place. Community investment involves a commitment to addressing social issues as well ; that is, recognizing that the allocation of capital in the community requires a commitment to meeting the needs of those people and groups who have typically been ignored by the traditional capital markets . Promoting local control of local resources and stopping the "leakage" of capital from poor communities are important goals of community investment . Community investment seeks not only to make capital available but to encourage the types of efforts and institutions that will make the best use of capital in the community. A successful program of community investment will stimulate the demand for development capital by supporting the formation of community projects and businesses and encouraging existing groups such as community development corporations (CDCs) to plan more projects . One of the greatest impediments to the formation of community development financial institutions is the lack of skills within the community economic development world to design, develop, and run community development financial institutions. This is especially true if community development banks have the mission of providing capital to communities, individuals and businesses that have traditionally been shut out of the capital markets. Over the last twenty years, many community economic development practitioners have focused on specific areas of development, i.e. housing, business development, job training, etc. The number of individuals truly committed to community economic development who have the necessary skills to operate a community development financial institution is relatively small. Without a plan to upgrading and training these individuals, such a program as the one proposed runs the risk of being overwhelmed by people who do not have a good understanding of community economic development. If only traditional financial institutions (i.e. commercial banks) are permitted to become community development banks, we could find that these institutions begin to develop an approach to community lending that is similar to what they already do. This would defeat the purpose of establishing community development banks in the first place. To successfully do community lending in the first place, those involved with the bank must have a broader perspective of the capital needs of a community than that now shared by traditional lenders. Community development financial institutions must be flexible to develop and utilize underwriting criteria that reflects the reality of the people, projects, and community in which they are lending. They must be able to establish underwriting criteria that would not necessarily match the criteria now used by traditional financial institutions. They must be able to offer a wider range of financial instruments including equity and subordinated debt. If community development financial institutions are really intended as institutions that can fill a needed gap (i.e., lack of capital for control of community resources), then community development financial institutions must provide or have access to a wide range of services including training and technical assistance to business borrowers, organizational development for organizations embarking on housing projects, and other support services for development. Of course, it may not be possible for a CDFI to provide this wide-range of services, but there should be some mechanism for other organizations to fill these roles. Without the ability to provide these services, community development financial institutions will begin to develop underwriting criteria that matches traditional banks, due to their perception of greater risk in lending to underdeveloped communities. Community development financial institutions must be able to offer a wider range of financing tools than traditional banks. These tools need to include the ability to provide equity, as well as a range of debt instruments. The present regulatory environment would make it difficult for commercial banks to address these financing 117 needs. This regulatory environment limits the types of risks that the bank can take, and limits the range of financial tools available to a bank. Development banking is common in many developing countries. These institutions provide financing in a manner that enhances the financial viability of the project or business seeking financing. The goal is a successful business or project, not necessarily a large return on investment. II. WHAT IS COMMUNITY DEVELOPMENT BANKING? a. Community development financial institutions must be permitted to develop and hold a long-term strategy for the economic development of the community that they serve. This will require that community development financial institutions (CDFI) be permitted to engage in long-term investment decisions of the community. This implies necessarily that CDFI's have the ability to actually invest, rather than loan money, to community development ventures. A primary goal of this initiative should be to support those CDFI's that have the ability to acquire equity positions in businesses through instruments such as preferred stock or royalty agreements. A CDFI should also be allowed to be a participating partner in housing and commercial development in the community. Return on equity can be realized in the form of a share of the net operating income of the project. Rather than be only a source of loans for development, a community development financial institution should have the authority and the purpose of truly investing in the community's ventures, and therefore in the community's future. This can not be done if the bank is restricted to lending alone. One of the primary goals of a CDFI should be to leverage private participation in the financing of ventures through its own investment in that venture. Financing by CDFI's should tie into broader financial markets, and utilize these markets as sources of investment. This can only be accomplished if CDFI's have the ability to utilize a wide range of financing tools suitable to each deal. b. A CDFI's primary goal should be providing access to capital to individuals, organizations, businesses, and communities that have traditionally be denied capital . Its goal should also be to assist the community in gaining control over the community's own resources . These goals can either take the form of revitalization of distressed areas, as well as improving the well-being of the residents of such areas. However, as a community starts to gain control over its resources through control of its land base, housing stock, and circulation of capital within the community, both of these objectives can be met. c. Any financial intermediary, profit or non-profit, including commercial banks, community development loan funds and community development credit unions should be eligible to receive investment from a Federal initiative. States and localities that have created or create specialized CDFI's should also be able to participate in a Federal initiative. For example, New Hampshire has created a Community Development Finance Authority (CDFA) that invests both equity and debt into community development projects and businesses. The money from CDFA comes from private business, which gets a tax credit for putting money into the CDFA. The Federal Government should review the CDFA legislation and experience in drafting its own initiative. d. One of the primary purposes of a community development financial institution should be to leverage and develop partnerships with the private sector. For example, a community development financial institution such as a community development loan fund should be encouraged to enter agreements with traditional lenders so as to leverage its own investment with money from the broader capital markets . The development of secondary market mechanisms is critical for CDFI's . Current secondary market mechanisms have been unresponsive to CDFI loans even when the pool of loans being offered by the CDFI is of extremely low risk . A Federal initiative for CDFI's should target the development of secondary market mechanisms as a priority of the initiative and/or stimulate existing Federally supported secondary markets to be more responsive to CDFI's. e. CDFI's should be permitted to offer a wide-range of community economic development programs under one roof. They should be permitted to operate micro-loan revolving funds, venture capital funds, housing loan funds, and programs that encourage the acquisition by community based organizations of their community's resources, especially land. They should also be able, through direct investment or loans, to participate in specific infrastructure projects that allow a community to develop. For instance, on many Native American reservations, access to electricity, water and sewers makes economic development difficult. A Community Development Bank should be permitted to become a partner, either through equity investments, or loans, with tribes seeking to develop these facilities. 118 III. HOW TO Finance CommuNITY DEVELOPMENT BANKS a. CDFI's can be financed through capital provided by the Federal Government, State government, private investors, and community organizations. Some of the financing can be through direct grants by the Federal, State and local government for initial capitalization and operating expenses. Other funds could be raised by changing the tax laws and the securities laws. b. States and local governments could be encouraged to either invest or provide loans to CDFI's through their CDBG funds . For every dollar invested of CDBG money in equity, the state of local government could receive 50 percent of additional CDBG funds. If the CDBG money is a loan, they could receive three (3) points above the interest charged to the CDFI for each year of the loan. In order to qualify, the CDFI must serve either the State or local government making the loan/investment. c. The Federal Reserve and its member banks should be allowed to loan to CDFI's at the Reserve or Banks' cost of funds. Other banks who make loans to CDFI's should be allowed to borrow money from the Fed or its members at reduced rates. d. Direct tax credits to private investors should also be considered as a possible way to finance community development banks. While this approach would have an impact on Government revenues, it is not inconsistent with the Administration's position on investment tax credits . The New Hampshire Community Development Finance Authority (CDFA) is a good example for utilizing tax credits to assist in the capitalization of CDFI's. Under this legislation, New Hampshire businesses are able to donate money or property to the CDFA, and receive a tax credit against their business profit tax. This tax credit may be spread out over more than one year, and the total amount any business can receive is limited. 119 PRINCIPLES OF COMMUNITY DEVELOPMENT LENDING & PROPOSALS FOR KEY FEDERAL SUPPORT Association for Enterprise Opportunity Chicago, IL Center for Community Self- Help Durham, NC Community Capital Bank Brooklyn, NY First Nations Development Institute Falmouth, VA National Association of Community Development Loan Funds Philadelphia, PA National Federation of Community Development Credit Unions New York , NY Woodstock Institute Chicago, IL 120 Contents 1. Overview 2. Statement ofNeed 3. AVision of Community Development Lending 4. Key Principles in Meeting Credit Needs in Lower-income Communities 5. Strategic Federal Support 6. Potential Funding Sources 7. Corresponding Federal Policy Changes 1. Overview Page 1 Page3 Page 4 Page5 Page 7 Page 9 Page10 Such institutions can only be established and grown gradually. resident Bill Clinton has dedared his intention to create a national system of 100 P community development banks over the next fouryears. Fortunately, an emerging industry of community development financial institutions (CDFIs) offers a solid foundation for this bold initiative, which might include new institutions, community organizations, conventional lenders, and others, in addition to CDFIs. The industry lends to low-income and , increasingly, to middle-income wage earners, small businesses,American Indian reservations, and communitydevelopment projects, complementingthework ofconventional lenders. Two factors argue in favor of the CDFI industry playing a lead role in a federally-assisted community development lending program. (1) The successful track record of community economicdevelopmentandgrowth fosteredby affordable credit through CDFIs is evidence that good borrowers come in greater variety than traditional underwriting methods often recognize. It is worth noting that CDFIs often provide a bridge between conventional lenders and unconventional borrowers, by creating new borrowers and opening new markets for thelenders while givingthe borrowers access to capital sources. (2) Effective community development lendingprograms are rooted in thecommunities they serve and are customized to fit those communities. This memo lays out the key principles that we, as communitydevelopmentlenders, believemustguide theClintonAdministration's communitydevelopment lending program and suggests several ways that the federal government can support the growth of the CDFI industry. To date, with almost no public support, CDFIs have proved that it is possible to mobilize and lend significant amounts of capital for development in low- and moderateincome communities. Our track record and experience can and should serve as a foundation for growth. With appropriate federal involvement, community development lending can help reduce poverty,countersocial and political disenfranchisement, and stoke the engines ofeconomic growth. The CDFI industry has developed over the last fifteenyears out of the determination and entrepreneurial spirit ofthousands of community activists, social investors, non-profit developers, and small business persons who correctly perceived that lack ofaccess to credit is a principal barrier to social and economic development. This industry comprises diverse institutions that serve a variety of credit needs in urban and rural communities. Included are: CommunityDevelopment Banks (CDBs), which are federally insured and regulated depository institutions that have been organized specificallyto provide capital to rebuild lower-income communities. Just four community develop- Principles of Community Development Lending & Proposals for Key Federal Support Page1 121 ment banks operate in the U.S. today. South Shore Bank in Chicago, Elk Horn Bank and Trust in Arkansas, Community Capital Bank in Brooklyn, NY, and the Self-Help Credit Union in North Carolina. South Shore Bank, Elk Hom Bank and Trust, and Self-Help Credit Union are part of larger bank or nonprofit holding companies that include independent, non-depository credit and support mechanisms such as venture capital funds, development loan funds, and technical assistance agencies. These non-depository institutions are able to be more pro-active in their development activities. • Community Development Credit Unions (CDCUs), which are regulated financial cooperatives owned and operated by lower-income persons. Typically, CDCUs provide consumer banking services (e.g., savings accounts, check cashing) that may not be locally available to their members, as well as personal loans for consumer goods purchases, home rehabilitation, and car purchases. A growing number of CDCUs are making development loans for small business expansion and start-up, home purchases, and housing rehabilitation . Prominent development lending credit unions include the Self-Help Credit Union in North Carolina,theAlternatives Federal Credit Union in Ithaca, NY, First Americans Credit Union in Window Rock, AZ, and the Santa Cruz Community Credit Union in Califomia CDCUs offer deposit insurance up to $ 100,000 per account through the National Credit Union Administration, which regulates the credit unions' activities. CDCUs are represented nationally by the National Federation of Community Development Credit Unions (NFCDCU) in New York City. •CommunityDevelopment Loan Funds (CDLFs), which are unregulated financial intermediaries that aggregatecapital from individual and institutional social investors at below-market rates and re-lend this money primarilyto non - profit housing and business developers in urban and rural lower-income communities . CDLFs place strong emphasis on financing projects that provide new economic opportunities and resources to borrowers and others in their communities. This generates economic leverage, enabling individuals and communitygroups to have avoice in communitybusiness, social, and political affairs. CDLFs have been leaders in financing community land trusts, cooperative housing (including mobile home parks), and worker/community-owned businesses. Prominent CDLFs indude the Low Income Housing Fund in San Francisco, the Federation ofAppalachian Housing Enterprises in Berea, KY, the Industrial Cooperatives Association Revolving Loan Fund in Boston, MA, and the Delaware Valley Community Reinvestment Fund in Philadelphia, PA. Loan funds are represented nationallybythe NationalAssociation ofCommunityDevelopmentLoan Funds (NACDLF) in Philadelphia, PA. •Micro-loan funds (MLFs) are most often components of micro enterprise development programs that integrate both economic and human development strategies. These programs aredesigned to fight poverty, increase incomes, raise self-esteem, stabilize families, develop personal, business and technical skills, createjobs and role models, as well as to spark a process of communityrenewal . The individuals served by these programs are predominantly women, often people of color, and almost all lowincome welfare recipients, unemployed, orthe workingpoor. Loans to micro enterprises range typically between $250 and $ 10,000 to startup or expand self-employment or micro businesses employing up to five people, normally family members. Theseventures include home day care, alterations and repair, fashion design and tailoring, catering and food service, hair and nail care, engine repair, trucking, retail and merchandising. Many micro enterprise development programs also offer additional financial services through partnerships with local banks or credit unions. Micro loans funds usually are capitalizedwith grants or loans from Principles of Community Development Lending & Proposals for Key Federal Support Page 2 122 foundations or government agencies or loans from banks or other financial institutions. Pioneered in the developing world by Accion International andBangladesh's Grameen Bank, microloan funds are relatively new to the U.S. Prominent micro enterprisedevelopment programs with MLF's indude Women Venture (formerly WEDCO) in Minneapolis, Minnesota, the Lakota Fund in South Dakota, Micro IndustryCredit Rural Organization (MICRO) in Tucson, Arizona, the Women's Self-Employment Project Chicago, Illinois, the Good Faith Fund in Arkansas, and the North Carolina Rural Economic Development Center. Over 150 micro enterprise development programs are represented nationally by the Association for EnterpriseOpportunity (AEO) in Chicago, Illinois. There are also a number of hybrid CDFIs that do not fit exactly into these categories but that provide critical financing to community development efforts. These hybrid institutions include NewYorkCity's Community Preservation Corporation , which has mobilized capital from banks, insurance companies, and pension funds for lowand moderate-income multifamily housing, and First Nations Development Institute's Oweesta Fund, which serves American Indian reservations. Inaddition, venture development funds like Northeast Ventures in Duluth , MN, Coastal Enterprises in Wiscosset, ME, and Eastside Community Investments in Indianapolis, IN, finance start-up businesses in urban and rural communities using equitycapital raised through foundations and government grants . These institutions are very much a part ofthe CDFI industry. They serve as models for other community development lenders, and they will be important to any effort to expand credit access in underserved markets. All of these CDFIs share certain public purpose values: ⚫tooffercreditto the poor and to thosewhose credit needs are not otherwise being met; • to spur community-wide economic and social development; ⚫ to provide the necessary technical assistance to borrowers to ensure the success ofloans andto build the capacity ofborrowers; ⚫ to use the lending process in away that encourages borrowers to participate in decision-making within their organizations and communities; ⚫ to enable individuals to gain self-sufficiency; and ⚫ to lend primarily for community development. Capitalized with more than $700 million-much ofwhich is raised from within the communities or constituencies they serve-development banks, credit unions, and loan funds have extended more than $2 billion in loans. Loss rates are comparable to the best conventional lenders. These CDFIs are proving: • that lower-income people and communities are credit-worthy; • that efforts to overcome chronic poverty depend on both access to credit and resources for capacity-building byindividuals and organizations, and ⚫ that conventional approaches to risk assessment andsecurity must be reexamined when serving borrowers with little or no credit history, business or development experience, or collateral. 2. Statement ofNeed The need for CDFIs and the affordable credit theyprovide has never been greater. TMuch as access to credit is a precondition for growth in small to large businesses, local access to affordable credit is a necessary antidote to poverty, economic disenfranchisement, and communityeconomic stagnation. Chronic poverty continues to increase in America. Government statistics released in the last quarter reveal that more Americans live inpoverty today than at any time in the last twenty years. Common ideas about poverty often overlook the fact that it is as prevalent in rural communities as it is in urban ones, while recent riots in Los Angeles and Washington Heights, NY, are evidence of the desperation such economic and social decline has caused. Poverty results not simply from a lack of resources or capacitybut also from patterns ofownership and Principles of Community Development Lending & Proposals for Key Federal Support Page 3 123 control ofland, housing, businesses, and financial institutions that draw resources out of lower-income communities and limit the ability of local residents and Tribes to invest in their own future. This is exacerbated by credit barriers and social divisions that limit or deny lower-income and working dass communities access to capital for community economic development. Providing development credit in low- and middleincome communities is vital to our nation's economic prospects. Small businesses will provide the greatest employment growth over the next two decades. CDFI lending programs encourage entrepreneurship, self-sufficiency, andcreative solutions, qualities thatwill be essential to economic recovery. CDFIs measuretheirsuccess not only bytheir own economic gains but also by their contributions to rebuilding the civic infrastructure of businesses, voluntary organizations, social services, and housing central to revitalization ofAmerica's working dass and poor communities. Current economic and political facts—the recent recession, astronomical government deficits, the savings andloan bailout, andthe health carecrisispreclude significant increases in federal, state, and local aid for existing community and economic developmentprograms. Bank industry mergersand proposed regulatory reforms have created and will create mega-financial institutions with minimal obligation, and ability to serve poor and middleincome communities. Financial institution consolidations will continue throughout the 1990's, reducing the number of banks in the U.S. from 12,000 to 8,000, while many of the remaining banks will focus not on the conventional banking and credit needs ofnew and small borrowers but on larger and more profitable customers. Most conventional lenders are further restrained by class and cultural barriers, the high cost of operations, and their commitment to profit maximization . The 1992 elections made it clear that the American public is looking for new ways to rebuild the civic infrastructure of businesses, voluntary organizations,communityservices, and housing upon which astrong democracy rests. President Clinton's proposal for a National Service Corps is a reflection of this spirit. Italsooffers an opportunity to linkpublic service to public support for community development lending by using the corps as the training ground for a new generation of community development lenders (see Section 5.C. below), one ofthe most important needs that must be met for community development lending to succeed. 3.AVision for Community Development Lending To servethe unmetandgrowingcredit needs oflocal communities, a national network TofCDFIsmust be fostered.)Existingpublic purpose lenders, particularly community development banks, communitydevelopment creditunions, community development loan funds, and microloan funds, comprise a solid basis for a nationwide network of community development financial institutions. Initially, efforts should be made to expand and adapt the models pioneered by North Carolina's Center for Community Self Help, Chicago's South Shore Bank, Arkansas's Elk Hom Bank & Trust, and Brooklyn, NY's , Community Capital Bank. Multi-service CDFIs have the greatest potential for growth, community development impact, and selfsufficiency. The bank or non-profit holding company structure enables the development intermediary to aggregate capital from within and outsidethe community through an insured depository institution . It also allows the institution to set up other credit and technical assistance affiliates. This type of organization can then pursue a coordinated development strategy that achieves an economy ofscale and the significant impact necessary for the revitalization ofurban and rural communities . This multiservice model should be considered the first-tier of CDFIs. •New organizations, conventional lenders, and insutuaons other than those mentioned here are also expected to be part ofthis network. This paper focuses on the types ofCDFIs described in Section 1. Principles of Community Development Lending & Proposals for Key Federal Support Page 4 70-832 - 93 - 5 124 At the second tier, the number ofCDFIs that have the capacity to step immediately into the multiservice model is limited to some 25-30 institutions. Indeed, significant support for capacity building will be needed to achieve President Clinton's goal of 100 multi-service CDFIs. This support will enable somemicro-loan funds to evolve into loan funds or • credit unions, small loan funds and credit unions to grow larger, and large, successful CDLFs and CDCUs to become multi-service institutions. A growth ladder ofthis typewill provide an important legacy for President Clinton-a national network of more than 100 multi-service CDFIs, as well as strong and enduring local institutions and revitalized communities across America. Pilot projects should be launched over the next four years to build on the foundation for 100 multiservicedevelopment financial institutions that will, in turn, demonstrate the value and feasibility ofa broader community development bankingsystem. Theseprojects must include support at bothtiers of the CDFI industry. Strong CDFIs should be selected for these efforts because they have: • Clear missions of communityeconomic development; •Demonstrateddevelopment lendingtrack records; • Accountability to investors or depositors and to the communities they serve, • Effective management, lending, investment, and technical assistance capabilities; • Established networks of investors and borrowers from which to launch a large-scale community revitalization initiative; and • Strong community support. Fivefactors will be critical to the success ofsuch pilot ventures and to a long-term effort to build a public purpose banking system : ( 1 )A base ofequity or net worth capable ofsustainingthe organizations as they grow; (2) Access to and control over longer-term, lowercost capital; (3)A long-term strategy for human capital development; (4) Public sector grants to support borrower techni- cal assistance services and new credit product development ventures; and (5) Continuedaccess to federal housing, enterprise, and social service development programs, as appropriate. 4. Key Principles in Meeting Credit Needs in Lower-Income Communities ix key principles should guide Clinton administration officials and Congressional Sleaders formulating this initiative: A) Community development "banks" should be defined to include the spectrum of community development financial institutions. A diversity of credit needs exist in poor communities; therefore, a range of institutions has evolved to serve these needs. To be effective, any Federal program must support a spectrum of institutions that have the following common attributes: 1 ) offer credit to low-and moderate-income people, small businesses, and communitydevelopment projects whose need for credit is not otherwise being met; 2) provide the necessary technical assistance to borrowers to ensure the success ofloans and to expand the capacity ofborrowers; 3) make credit decisions within their own institutions so that local , regional, or state factors, as appropriate, are properly weighed; 4) foster community-wide economic and social development; and 5) empower disenfranchised individuals and communities to gain self-sufficiency. B) Expand the scope ofcommunity development bank lending beyond small business credit. The Clinton plan articulated during the campaign seems to assume that community development lending would be primarily, if not entirely, business oriented. We strongly recommend that a successful program must also include housing lending, consumer lending, retail banking, and other credit needs (e.g., working capital and facilities development loans for non-profit social service providers andTribes) in working class and low-income com- Principles of Community Development Lending & Proposals for Key Federal Support Page5 125 munities. Healthy communities are made up of a variety of institutions and persons with diverse credit needs. Failure to respond to this broad range ofcreditdemands will needlesslylimit any community revitalization strategy. C)Consult experiencedcommunitydevelopment ⚫• financial institutions in crafting legislation and operatingtheCDFI network. 42 loan funds, 100 community development credit unions, and 4 development banks manage approximately $700 million in private capital and have proven lending track records. •SouthShoreBank in Chicago, CommunityCapital Bank in Brooklyn, NY, Elk Hom Bank & Trust in Arkansas, and the Self-Help Credit Union in NorthCarolina have loan loss rates at or below the level of their peer depository institutions. •Accordingto the National Federation ofCommunityDevelopment Credit Unions (NFCDCU), community development credit unions have loaned more than $2 billion. NFCDCU's members' loss rate on loans on average is less than 2%. •NACDLF members have loaned more than$ 100 million, which has leveraged $760 million in public and private capital to finance 15,000 housingunits and to create 6,100 jobs for poor Americans. NACDLF members loss rate on loans is less than 1%. D) Emphasize expansion of existing community development financial institutions rather than simply undertake wholesale efforts to create new development banks. Existing institutions should be supported to expand their activities because they know their markets and because they have proven that they can lend successfully in low- and moderate-income communities. Most CDFIs are undercapitalized and operate with inadequate net worth levels, requiring them to divert resources from workingwith borrowers to seeking potential funding sources. At the same time, the demand for affordable credit in most cases far outstrips the supply. An attempt to franchise or otherwise mass produce CDFIs is not likely to be able to meet this demand. Successful CDFIs are, as we have noted, rooted in the communities, states, and regions that theyserve. Most draw their lending capital from their service areas, and their boards ofdirectors reflect the composition oftheir communities . This makes it possible for them to gain therequisite understanding of credit needs and borrower capacity to gauge their lendingproperly. Institutions created without these strengths and operating with a mandate to lend quicklyand in a safe and sound manner will carry a heavy burden ofunachievable expectations. In areas not presently served by a CDFI , the federal government consider fostering development ofa newone. E) Recognize that successful development lending institutions arebuilt over time andwithincremental performance-based financial support. South Shore Bank in Chicago and the Center for CommunitySelf-Help in North Carolina have reached their current levels after 20 years and 10 years respectively. Development finance is a highly specialized enterprise requiring uniquely skilled personnel,detailed market knowledge, and local institutional credibility. This skill and trust cannot be bought with massive federal appropriations but must be built over timethrough sound lendingand borrower capacity-building programs. Any other approach invites repetition of past federal antipoverty initiatives that produced fraud and abuse. F) Clarifythe different interests and responsibilities ofconventional lenders, public agencies, and CDFIs. The notion that CDFIs will take business away from conventional lenders is not likely to come to pass. Loan funds, credit unions, and development banks operate almost entirely in separate markets from those served by conventional lenders. Historically, CDFIs have been a breeding ground for new borrowers from conventional institutions , serving as bridges giving banks and others access to new markets. The difficulties of gauging credit risk among new or unestablished borrowers, lack of market knowledge, inadequate development lending expertise, and changes in the global financial system pose significant-though not insurmount- Principles of Community Development Lending & Proposals for Key Federal Support Page 126 able-hurdles for conventional lenders interested in playing an expanded role in these communities under the Clinton Administration's community development lending initiative. Public agency programs often are bureaucratic andhighlypoliticized. Instead ofservingborrowers' needs,these programs can stifle the entrepreneurial initiative that community development financial institutions successfully foster. Community developmentlendingrequires highly specialized business skills and a commitment to sound business practices. It is often difficult to foster these qualities in the public sector.. As a result, we believe that existing CDFIs shouldbethefoundation foran expanded communitydevelopment lending initiative, as stated above. Twokey responsibilities ofconventional lenders as part ofthis program need to be articulated, however, to ensure that the broader purposes of the Clinton community development banking program are met: • Continue the Community Reinvestment Act (CRA) and expand community reinvestment lending. The creation of a CDFI network underthe Clinton Administration must notbe a substitute for the CRA. It is our experience that even ifthe Clinton plan for 100 CDFIs were fully realized in 1993 there would still be anoverwhelmingdemand for affordable credit in America's distressed urban, suburban, and rural communities. New York City alone has a $30 billion affordable housing credit shortfall. The federal government could support community development in general by extending the reach ofthe CRA. At the same time, an expanded CDFI industrywill provide conventional lenders with ameans to participate in community development lending at substantially reduced risk and lower transaction costs. Many CDFIs have worked successfully with conventional lenders. The Low Income Housing Fund (LIHF) of San Francisco, CA, has pioneered the use of innovative financing mechanisms such as loan packaging to help conventional lenders make community development loans. LIHF cur- rendy manages some $ 16 million in two loan pools in San Francisco and Los Angeles. • Link creation of a national system of CDFIs to future financial support for and regulation of the conventional financial industry. The private banking system and capital markets have undergone a profound restructuring over the past 20 years. Banking industry deregulation, growth in the conventional paper markets, insurance industry expansion , and the increasingrole ofunregulated financial intermediaries such as mortgage banks andfinance companies have left manylowerand middle-incomeAmericans, small businesses, and poor communities without access to affordable credit. This restructuring has been made possible through myriad government subsidies to conventional financial institutions (e.g. , federal deposit insurance, state insurance guarantee funds, Federal Reserve Discount Window borrowings, etc.). Government subsidies and new powers should begranted to the financial industryonly if it meets quantifiable community lending objectives and provides ongoing financial support tothedeveloping nationalsystem ofCDFIs. 5. Strategic Federal Support ederal support should be provided to foster the development ofa national system ofcomF munity development financial institutions: A) EquityCapital orNet Worth Grants: Sufficient levels of equity(for for-profit lenders) or net worth (for non-profit lenders) is critical to the long-term viability ofany financial institution . Access to adequate amounts of equity or net worth is the principal impediment tothe creation and/orgrowth ofmostCDFIs . Only four development banks have been created in the past 20 years , primarily because of the difficulty in raising equity or net worth capital . Distribution of equity funding under a federal program should use a performance-based process (see Section 7). Equity or net worth capital is critical to all financial institutions: Principles of Community Development Lending & Proposals for Key Federal Support Page 127 •Itpermits greater risk in lendingto borrowers with limited credit histories by providing investors adequate protection; •It enablesflexible loan pricing and longerterms, as needed; •It permits lenders to refinance balloon loans made toborrowerswhen designated take-out financing is delayed; • It protects investors from borrower defaults if allocated loss reserves are exhausted; • It gives CDFIs the financial clout to attract new investments from sources thar traditionallyhave not supported them— such as insurance companies, banks, mutual funds, and universities-and that require minimum net worth levels; and • It generates 100% earnings as "spread," giving CDFIs the financial independence to forge creativepartnershipswith borrowers. Thespread subsidizes borrower technical assistance, which makes development lending viable. B) Below-Market & Long-Term Deposits or Loans: The costs of doing community developmentlending are higherthan the costs oftraditional conventional lending, in large part because each loan requires the lender to provide technical assistance to the borrower. In addition, the underwriting process is unique for each loan. To insure borrowersuccess, ongoing technical assistance often is required long after loans are closed. The interestearned on below-market deposits or capital helps to payfor this assistance. ManyCDFIs also facethe challenge of using shortterm capital (for non-depository institutions) or deposits tofund long-term projects. Housinglenders by necessity often make balloon loans without take-outfinancingin place . Conventional banks are hesitant to participate in or to refinance these loans for various reasons, including ( 1 ) lack offamiliarity with the nonconforming, original underwriting of most CDFI loans, (2) terms and pricing that maybe unattractive, (3) the lack of credit enhancements such as loan guarantees and interest rate subsidies, (4) the lack of a specialized secondary market for community development loans, (5) lack ofexperi- ence with development lending markets, (6) high transactions costs, and (7) a misperception ofsubstantially higher risk in development lending. Longer-term deposits make longer-term lending feasible for CDFIs. C)Human CapitalDevelopment: Efforts to create a national system of community development financial institutions will only be successful if a generation ofdirectors, managers, and loan officers can be recruited and trained to operate these intermediaries. Development lending and public purpose bank management require specialized knowledge and technical skills, strong social commitments, and extensive community experience, all of which differ in important ways from the skills needed to run a conventional financial institution. Community development lenders should undertake, with Federal support, several initiatives to developthe next generation ofcommunity bankers and trustees needed to operate and to govern an expanded network of community development financial institutions. These initiatives could include: • Creation of a three-year internship/apprenticeship program at community development financial institutions. This internship would be similar to in-house conventional/investment bank training programs but would also attend tothe economic, social , and intellectual formation ofparticipants. This program could dovetail with President Clinton's plans for a National Service Corps by placing talented young adults in training for productive careers in community development and community development finance. • Forging cooperative training agreements with select university business schools and conventional financial institutions to complementthe apprentice program outlined above. · Sponsoring regular seminars on capital access, communityleadership, public investment, and economic democracy issues for CDFI board and staff members. The federal program also should include a Principles of Community Development Lending & Proposals for Key Federal Support Page 8 128 research program to assess the long-term economic and social issues affecting the CDFI industry and the communities its members serve. • D)BorrowerTechnicalAssistance andNewCredit Products Development Funding: CDFIs serve a market of institutions and individuals who have been unable to gain access to credit. Typically, CDFI customers arefirst-time borrowers with little credit historyor development experience. Ongoing technical assistance is critical to successful CDFI lending to housing developers, first-time homeowners, small businesses, and non-profit service providers. The business planning, financial management, and marketing assistance CDFIs provide to their borrowers to build skills is labor intensive and raises transaction costs, ultimately lowering profit margins. It is necessary because it helps to ensure loan repayment and long-term borrower success. To serve this market effectively, CDFIs have created specialized technical assistance programs. CDFIs also continually develop and market new loan products to serve emerging credit needs. The marketanalysis, product research, andproduct development costs incurred by CDFIs are substantial. Support forthese capacity building programs is essential in three areas: • Technical assistance to first-time borrowers or organizations undertaking new housing/business development ventures; • Technical assistance to help secure conventional lenderfinancing for current CDFI borrowers; and • New credit product development by CDFIs to meet emerging credit needs of new borrowers. 6. Potential Funding Sources DFIs offer the Clinton Administration a unique opportunity to demonstrate its commitment to economic programs that eschew the "hand out" model, that encourage and abet entrepreneurship, that foster economic selfsufficiency, that support economic growth at the community level where its impact is greatest, and that reward economic and social accountability. CDFI funding should not come exdusively from adirectfederal appropriation but should draw also on the public responsibilities of the federally insured and subsidized conventional financial markets. Those institutions which benefit from public subsidy oftheir lending or other financial services (eg., deposit insurance, insurance and pension fund guarantees) could reasonably be expected to contribute in various ways to meeting credit needs they are unable to address directly. Several possible financing mechanisms could complement direct Congressional appropriations for the Clinton CDFI program. These include: commercial bank commitments of equity capital andothersupport to CDFIs as an outcome ofCRA negotiations or mega-bank mergers; a share ofthe profits from appreciation of federally sold assets (e.g., a percentage recapture levy on Resolution Trust Corporation properties); a share of profits from government-sponsored enterprises such as Fannie Maeand Freddie Mac; and CDFI set-asides within major legislation to bail out the S&L industry or inject capital into other parts ofthe financial services industry. A combination of such modest measures couldyield hundreds ofmillions ofdollars of capital needed to build a vibrant, large-scale CDFI sector. Inaddition, theClinton Administration should considercarrots and sticks for commercial financial institutions to provide long-term, low-cost capital to the CDFI sector. Measures such as requiring conventional lenders, pension funds, investment banks, insurance companies, mortgage companies, andfinancecompanies to place a very small proportion of their overall assets with CDFIs would yield enormous public benefits in the form of jobs, affordable housing, and increased ownership opportunities. It would also underscore the expectation that such institutions that receive public subsidies have special responsibilities to see that community credit needs are met. Finally, the Clinton Administration should considerincentives to increase investmentin CDFIs by America's major wealth-builders- individuals. CDFIs have proven their ability to raise private capital for community investment from individu- Principles of Community Development Lending & Proposals for Key Federal Support Page9 129 als. This could be significantly enhanced iffederal tax laws were amended to provide tax-free interest to individuals who make below-market communitydevelopment investments or deposits in loan funds, credit unions, micro-loan funds, and developmentbanks. This incentive would be available to individuals at all incomelevels, would give investors (or depositors) the equivalent of market-rate returns, and would- via CDFIs-strengthen communities socially and economically. 7. Corresponding Federal Policy Changes federal policy of supporting community development finance must extend beyond Athe proposed network of 100 CDFIs. The ClintonAdministration can back up its investment inCDFIs bya series ofadministrative and legislative initiatives: • Simplify public sector credit enhancement programs to non-profit CDFIs. Partial and full loan guarantees, for example, could significandy increasethe ability ofCDFIs to leverage both public and private investment dollars. TheCommunity Preservation Corporation in New YorkCityhas successfullyused municipal and state guarantee programs to direct more than$1 billion in bank, insurance industry, and municipal pension fund moneys to affordable housing lending. Farmers Home Administration, Federal Housing Administration, and Veterans Administration programs could be usedto replicate this model with CDFIs across the nation. Similarly, South Shore Bank isthe largest Small Business Administration (SBA) lender in Chicago. Beneficiaries are primarily minority-owned businesses. Non-depository CDFIs could increase their business lending if SBA rules were modified to simplify the requirements on non-bank lenders. This adaptation would also increase the number ofminorities, women, and rural businesses receiving SBA support. • Require government-sponsored enterprises (GSES)-Fannie Mae, Freddie Mac, Ginnie Mae-to develop customized secondarymarket programs for housing and business loans originated byCDFIs. To date, GSEs have been almost completely unresponsive to CDFIs. CDFIs' performing loans are judged by standardized underwriting criteria that are largely irrelevant to CDFIs' lending market. CDFIs cannot grow and prosper unless an active secondary marketis fostered fortheir loans. Existing GSES have an obligation to serve this market aggressively and can do it profitably. CDFIs' lending track record has spurred great interest among social investors-such as religious and municipal pension funds-to purchase performing community development loans through private placement mechanisms. • Ensure public accountability ofall CDFIs. Limited federal oversight will be necessary to administer the CDFI initiative and to ensure publicaccountability. Regulatoryand program evaluation standards, however, mustbefounded in the current policies and practices of the diverse range of CDFIs. We recommend that the Clinton community development initiative relyprimarilyon performance-based funding to encourage the use of "best available” practices and to enable the industry to grow into a highly effective national system . This approach ensures that recipients offederal support build capacity as they grow. We recommend that two principles should guide this approach: (1) Oversight and evaluation should be performance-based. Anewfederal communitydevelopment program would be remiss ifit used a strict selection process for participants that excluded a significant sector of the CDFI industry. The only way to build a national network of 100 or more depository CDFIs is to seed the existing industry broadly and then to allocate resources to those organizations that meet negotiated performance targets. This process will allow a range of approaches while ensuring a fairlevel ofreturn. In addition, itwill allow the most innovative and determined Principles of Community Development Lending & Proposals for Key Federal Support Page 10 130 lenders togrowwhile the others dropout ofthe national system . 1January , 993 25 (2) Performance evaluation should be outcomebased. No two CDFIs will operate alike. Each willhave uniquetargetgroups, activities, methods, procedures, and priorities, depending on thecharacteristics ofthecommunities in which they lend. A federal attempt to micro-manage all CDFI lending by requiring, for example, federalsign-offs on individual loans oruniform underwriting or loan servicing guidelines will be counter-productive. Ultimately, it will fail. Instead, federal oversight officials should nego- tiate expected institutional outcomes with each recipient within a range ofstatutorily acceptableoutcomes that are related to theinstitution's primary mission ofproviding credit for community and economic development. Performance evaluation should focus on the CDFI's success at achievingthese outcomes. Outcome criteria should be established for, among other things,lendingvolume, portfolio performance, capacity building, and program results (e.g. , service to targeted constituencies), and should be measured overan extended time period that allows for accurate assessment ofsuccess. Principles of Community Development Lending & Proposals for Key Federal Support Page 11 131 ACORN February 17 , 1993 The Honorable Donald W. Riegle Chairman Committee on Banking , Housing, and Urban Affairs U.S. Senate Washington, D.C. 20510 4 Dear Chairman Riegle: I appreciate the opportunity to offer comments on aspects of the Clinton Administration's proposal to create a network of community development banks . I wish to make absolutely clear that ACORN strongly opposes any initiative that would dilute the community reinvestment obligations of existing insured depository institutions . In particular , we oppose efforts to allow existing institutions to receive oredit" under the Community Reinvestment Act ( CRA) for equity investments or loan participations with community development banks . " The Clinton community development bank proposal can be an important vehicle for focusing attention on development needs , targeting funds, and rallying local communities in revitalization efforts. As part of a comprehensive strategy to increase credit availability for underserved sectors and distressed communities , the creation of new community development banks can make a real difference . The appropriate role of such institutions will , however, probably be to act an incubator of innovation, and to demonstrate to the industry at large that community lending can be done profitably and with minimal risk. Expecting such institutions to solve by themselves the range of credit availability problems in America, however, will be a recipe for failure. I would like to lay out six broad principles for the Committee as it considers various proposals . a. Do not lessen the existing community reinvestment responsibilities of depository institutions , and work with the new Administration to realize CRA's immense potential. Community development banks , whatever their structure , cannot Association of Community Organizations for Reform Now National Office: 739 8th Street S.E. , Washington, D.C. 20003 - 202-547-9292 FAX 202-546-2483 132 Reinvestment Act (CRA) enforcement . As always happens when a new program is created, the vultures appear on the scene to grab whatever advantage possible. The banking trade groups are clearly seizing on the community development banks as a backdoor means of escaping their responsibilities under the CRA. They want to contribute a few pennies to the new banks --maybe a desk blotter and handful of ballpoint pens-- and then get an "outstanding" CRA rating. This way the bankers figure they'll be free of low-income people in their lobbies and hassles about home mortgages from the wrong side of town . In addition, providing CRA "credit" for contributions to community development banks would unfairly penalize banks that have learned how to land in low-income neighborhoods profitably and with minimal risk, and reward the negligent portion of the industry that has never complied with the law. 1 A report by the Senate Subcommittee on Housing and Community Development last year highlighted how much can be accomplished by a new Administration committed to vigorous enforcement of the Community Reinvestment Act (CRA) . The Report on the Status of the Community Reinvestment Act found in November, 1992 that CRA had had "noteworthy success , " and that " [ c}ommunity groups working with the private sector have generated more than $30 billion in the last decade for reinvestment in underserved communities . " The report credited CRA as "the impetus for developing partnerships between financial institutions and communities; for providing access to capital to communities traditionally underserved ; and for creating new, innovative methods for meeting the credit needs of all segments of the community. " The report want on to note that CRA had not achieved its potential because of regulatory malfeasance . "It is clear from the Subcommittee's review that the regulatory agencies have yet to fulfill their obligation to ensure that the CRA is properly and completely implemented . The supervisory agencies record of inconsistent and lax enforcement has encouraged the indifference and disinterest by the financial institutions . As a consequence , the agencies bear significant reponsibility for the poor performance of many of the financial institutions ... Inconsistent implementation and enforcement dininishes the CRA's tremendous potential , deprives neighborhoods and communities of one of the most effective Federal tools available to assist in meeting their credit needs , and denies financial institutions the benefits of a consistent , fair regulatory regime ... The message is clear. CRA is a law whose purpose is as relevant today 2 133 as when it was written 15 years ago. The issue is obt the law, but: its implementation and enforcement . Among the flaws in regulatory performance identified by the report were: grade inflation, uneven quality of evaluations , lack of clarity about CRA's goals, inattention to identified cases of discrimination , | infrequent use of enforcement powers , lack of attention to lending data in assessing performance, and obstruction of community input into the regulatory process . With reference to community development banks, the report specifically cautioned that " community development banks can only be one component of a CRA program. Financial institutions cannot "buy out" of their CRA responsibilities to the entire community by simply participating in a community development bank. " ' Great strides can be made in increasing credit availability for distressed urban and rural commnities by strengthening enforcement of the CRA. Specifically, the Committee should work with the new Administration to: 1 *require the agencies to conduct more rigorous evaluations of lenders , and establish more rigorous standards for evaluations ; ! *nake greater use of performance data in examinations and evaualuations ; *conduct more frequent exams, particularly in the case of the Occ, and provide better training for examiners ; *make more frequent use of available enforcement tools , such as cease and desist orders and the denial of merger applications ; *facilitate , rather than obstruct , community input into the CRA process , and recognize partnerships between community groups and other local groups with lenders as an important component of a sound CRA program; *collect more data in a more useful form, particularly on lending to small businesses ; and *in the case of banks operating in multiple MSAS in a state, conduct separate CRA evaluations for each MSA served by the institution, and one for rural portions of the state . b. Use federal funds to support a range of community lending initiatives. Different communities have different needs , and no " cookie cutter" solution imposed from Washington , D.C. will solve the problem. Community development banks , credit unions, and loan funds, as well as credit programs established by non-profit community and housing development organizations are all legitimate mechanisms to increase the flow of credit into underserved 3 134 communities . Specifically, the proposal could: dramatically increase the $6 million available at the National Credit Union Administration for promotion and creation of CDCUS . explore ways of focussing the National Cooperative Bank -created and capitalized by the federal government in 1978-- on providing credit and technical assistance in underserved areas . + * allow local communities that wish to apply for federal funds to select the most appropriate vehicle for extending credit : a community development bank, a community development credit union, a community development loan fund, or a credit program run by a community or housing development organization . o. Mazinize participation of local residents in the creation and governance of new institutions in low-income neighborhoods i Credit programs imposed on communities by outsiders are doomed to failure . Community ownership, control, and governance must be at the heart of any community development bank proposal . Low- and moderate-income and minority neighborhoods have suffered for too long from loan policies imposed from downtown by boards of directors and loan officers who cannot grasp the realities of life in their communities and cannot understand why " one size fit all" loan standards impose unnecessary barriers . We must have people on the boards of directors of these new institutions who are from the community and have a lifetime commitment to improving it , and who know the neighborhoods and its needs . We recognize the importance run these institutions . But the must be drawn from the community truly contribute to neighborhood they are not to be resented. of having qualified management to directors --the policy makers-if these institutions are to revitalization, and indeed if Sufficient funding must be provided for a strong outreach and technical assistance program. The administrative entity overseeing the disbursement of federal funds --HUD or a new independent agency-- must have field staff whose job is to work with residents of low-income neighborhoods , organize meetings , build support and ownership, and assist in the development of proposals to establish new institutions. d. Prioritize the creation of new institutions in truly distressed areas , and require applicants for federal funds to direct the bulk of their lending to projects which benefit lowincome families.. There is an "upward creep" with regard to many federal programs , so that initiatives that start with inner-cities in mind often end up serving a middle- or upper-income constitutency in practice. It is essential that priority in funding be given to 135 proposal that will serve a demonstrably underserved population . We strongly urge the Committee to target funds for new institutions only to communities with a median Income that is less than 80% of the Area Median Income (AMI) . In addition, applicants for federal funds should be required to state a commitment to directing the overwhelming bulk of their lending to a target distressed community, and be held accountable failing to meet those targets . We suggest that applicants for • for federal monies be required to commit that no less than 80% of their total originations be in neighborhoods at or below 80% of AMI, and further than they maintain a loan-to-asset ratio no less than 70%.. e . Recognize the constraints facing many community-based organizations , and do not impose unreasonable "match" requirements on them Many underserved communities may be able to "match " public equity contributions with private capital. Given, however, the scarcity of socially responsible investors --upon which many existing alternative financial institutions rely-- and the realities of low- and very-low income communities , a 1 : 1 or 2 : 1 match may not be realistic in all cases. We suggest allowing for a reduced match --or a waiver-- for applicants proposing to serve a low- or very-low income community. 1. Fund the program at a reasonable level , to ensure the viability of new institutions . We have been disturbed by news reports that suggest that the President might allocate only $850 million for 100 development banks. This would suggest almost a boutique, demonstration program, creating institutions with little equity capital and therfore with little lending muscle . These institutions must not be established on a shoe string. They must be put on a solid footing, even if that means proceeding at a more deliberate pace or creating fewer institutions . We appreciate the opportunity to comment, and look forward to working with the Committee as it crafts community lending legislation. Sincerely Deepak Bhargava Legislative Director 136 STATEMENT OF THE NATIONAL ASSOCIATION OF HOME BUILDERS SUBMITTED TO THE SENATE COMMITTEE ON BANKING , HOUSING AND URBAN AFFAIRS CONCERNING COMMUNITY DEVELOPMENT BANKS FEBRUARY 3 , 1993 137 The National Association of Home Builders (NAHB) , representing 157,000 member firms, would like to take this opportunity to present its views on the role of community development banks in alleviating the credit crunch for small business and creation of economic growth. As an Association which is comprised of builders who are primarily small business persons , NAHB supports the concept of " community development" banking . Some institutional structures to support community development banks already exist. Specifically, the Federal Home Loan Bank (FHLB) System could provide not only a supportive structure , but a variety of programs and services, which would enable community development banks to better carry out their mission. This could be accomplished with no budgetary impact. HOME BUILDERS ARE PRIMARILY SMALL BUSINESS PEOPLE The nation's home building industry is dominated by a great many small builders operating in limited geographic areas, generally local markets. The last census of the construction industry ( 1987) estimated the number of residential builders with at least one employee on the payroll at about 120,000 firms . About 75 percent of home building companies build 25 units or fewer per year, and more than two-thirds of these build only ten units or fewer. Only 8 percent of home builders are considered to be "large; " that is, building 100 or more units per year. In addition , most of the subcontractors and many of the suppliers to these builders are small businesses themselves and are heavily reliant on home builders for their livelihood . In view of the structure of the industry and the heavy reliance of builders on thrifts and banks for housing production credit, it is not hard to see why home builders have been particularly hard hit by the credit crunch affecting small businesses. THE CREDIT CRUNCH AS A FACTOR IN THE NATION'S ECONOMIC RECOVERY The impact ofthe credit crunch on small business and the resulting debilitating repercussions throughout the economy has been widely acknowledged both during the presidential campaign and by the current Clinton administration . On November 18, 1992 , Alan Greenspan , Chairman of the Federal Reserve Board made the following observations about the credit crunch , its impact on small business and the nation's economic recovery : "One of the most disturbing elements of the current subpar recovery has been the extraordinary debilitation of our financial intermediation process...This is especially distressing because banks are the major , and in many areas , almost the sole marginal suppliers of credit to small and medium sized businesses. Small firms are the core of entrepreneurial effort in the American economy and historically have been ... a major force for job creation . 2 138 Hence, it is essential that the bank loan markets be restored to a semblance of vigor if adequate financing of overall economic growth is to reemerge...the credit crunch is not the only reason for the disappointing performance of the economy...But the state of bank loan markets certainly is a key element... An impressive number of worthy applicants has been rejected ...When real estate loans became a black mark against bank credit ratings, such loans were reduced, not only by write-offs but by pressing solvent borrowers to repay because they were the only ones who could . That sounds more like fear than sound banking practice. " As Chairman Greenspan points out, residential lending has been particularly hard hit in the past three years as many loan worthy applicants have been rejected by banks because of their association with commercial real estate loan problems. This failure to distinguish residential real estate loans from commercial real estate loans has added insult to injury for small business persons , who are also home builders. First, as small business persons, to whom lenders have tended toward extreme caution when making loàns , and second , as home builders seeking real estate loans. HOME CONSTRUCTION AND ITS IMPACT ON ECONOMIC GROWTH Economic data provide salient evidence that home construction can provide a powerful stimulus to the economy. The home building industry stands poised to spawn such economic growth . According to the Bureau of Labor Statistics , the direct and indirect impact of construction of one single family home with a median price of $120,00 and a median size of 1,890 feet, generates 1.759 work-years of employment in construction and related industries. Construction employment accounts for .627 work-years, land development for .235 work-years, and other industries for.897 work-years. Based on the average wages for these industries in 1990, this employment impact translates into an additional $45,700 in wages and $18,800 of tax revenues at all levels of government. (For additional details , please see Table I on page 9 and accompanying explanation . ) The cumulative annual impact on the economy as a whole can be determined by using 1990 figures for single-family housing starts and hourly wages. In 1990, there were 895,000 housing starts and the " average " price of a single-family home was $ 128,000 . The construction of one average priced home generates 2.15 workyears of employment in construction and related industries. Based on the average wages for these industries in 1990, this employment impact translates into a total of 1,924,000 labor years which generates $ 226.6 billion , or 4.1 % of the gross domestic product. 3 139 COMMUNITY DEVELOPMENT BANKS Since the presidential campaign, the public has heard a great deal of President Clinton's vision for a nationwide system of 100 " community development banks" . The concept of " community development banks" and their place in the overall banking scheme is still taking shape . However, the general consensus appears to be that "community development" banking would spawn development, and the ripple effect would be felt throughout the community in terms of credit availability, growth and development, employment and wages, leading to greater prosperity: These banks would receive some federal assistance in the form of grants, to be matched by the individual bank, and would restrict their lending to true community development activities such as housing and small business loans in their areas. As a presidential candidate, Mr. Clinton frequently pointed to the South Shore Bank of Chicago as the model for his vision of a " community development bank". CHARACTERISTICS OF THE SOUTH SHORE BANK OF CHICAGO The South Shore Bank is a subsidiary of a bank holding company, which is regulated by the Federal Reserve Board . The South Shore Bank is a state-chartered, full-service commercial bank whose investors and depositors are willing to accept less competitive returns in order to promote community development. The bank is owned by a holding company whose affiliates include: (1) a for-profit real estate development corporation ; (2) a non-profit subsidiary providing technical and community services; and (3) a small business investment corporation . Although the bank restricts itself to community development lending , it operates under a traditional charter and does not require a new chartering system. RECOMMENDATIONS OF INNOVATIVE FEDERAL SUPPORTS FOR HOUSING PRODUCTION CREDIT Public and private institutional structures that can support housing production are already in place and may be built upon with little or no federal budget outlays. These structures already provide a variety of federal supports for the home mortgage finance system, including mortgage insurance and guarantee programs, secondary market agencies, and the Federal Home Loan Bank System that lends to member depository institutions that provide housing finance. However, the federal government has provided virtually no support to the markets for housing production loans. Thus, when the credit crunch developed at the traditional sources of housing production finance--thrift institutions and commercial banks--there were no secondary market channels or credit instruments to attract funds from alternative sources. 140 Enhanced credit supports that are grounded on loan guarantees, purchases of loan participation or loans to private lenders would be powerful supplements to housing production lending by thrifts and banks operating in a more positive regulat: ry environment. Such support mechanisms would be important factors in achieving the goals of community investment initiatives, such as community development banks. NAHB believes that a network of " community development banks" could be sustained and enhanced by the Federal Home Loan Bank (FHLB) System . : THE FEDERAL HOME LOAN BANK SYSTEM The Federal Home Loan Bank System , comprised of 12 regional Federal Home Loan Banks , was established in 1932 to bolster housing lending by providing a credit support mechanism for home mortgage lending by depository institutions. The membership of the System has traditionally been dominated by savings institutions. In 1989 , commercial banks and credit unions were given the option of membership; and now comprise one-third of the System's members. Nevertheless , thrift members continue to enjoy more beneficial treatment in borrowing than bank and credit union members. The FHLB System has been an important component of the nation's housing finance system for decades. However, shrinkage in the number of savings institutions , and the impediments to banks' more recent participation in the System, have made it difficult for the FHLBanks to fully utilize their resources in support of housing. The nation's housing credit needs have also changed and restructured , and the System finds itself in search for new roles to play as demand for its traditional services declines. The System has a strong capital base . Under current operating limitations, however, it is unable to generate the levels of business and earnings needed to attract new members and maintain its vital role in supporting the funding of housing. The FHLBanks currently may invest in only one type of credit product to their member thrifts and banks -- advances that must be fully secured with narrowly defined collateral . The types of residential real estate collateral that members currently can use, without restriction , to secure advances are limited to whole first mortgages and mortgage- backed securities. If the FHLBanks are to take a more positive role in supporting housing, then their credit products for their members and their collateralization requirements must be expanded . Although new credit products and more flexible collateralization requirements would mean that the FHLBanks could assume some direct or indirect credit risk , the FHLBanks have more than enough capital to support such expanded services. Furthermore , the FHLBanks are capable of successfully managing and diversifying additional activities having favorable riskreturn relationships that are needed to attract and retain members . 5 141 CREDIT SUPPORT FOR HOUSING PRODUCTION LENDING An area of great need for the housing sector, and of great potential for the FHLB System , is housing production credit. There are several ways in which the FHLBanks' current operating authority needs to be changed in order for them to be an effective support for housing production lending by their members . Loan Participations and Credit Enhancements . A change in the FHLBanks' investment authority, to let them invest in more types of credit products than just the existing type of advance , would allow member institutions greater flexibility in structuring loans. In particular, the FHLBanks should be allowed to purchase participation interests in housing production loans originated by member lending institutions. The FHLBanks could hold these participations interests as investments, or resell them to outside investors. This function would allow member institutions to better leverage funds for housing production while observing regulatory constraints on loans to one borrower, asset concentration , and geographic concentration . In addition , the FHLBanks should be able to provide credit enhancements, such as subordinated interests, for loan participations that they resell. This authority would facilitate secondary market activity and liquidity for housing production loans. Flexibility in Collateral for Advances . Advances must be fully secured by government securities or certain housing-related assets. Currently, the only types of housing assets that may be used , without restriction , are fully disbursed whole first mortgages and mortgage securities backed by such mortgages. Member institutions may also secure advances with real estate-related participation interests, residential production loans, nonresidential real estate , and other types of mortgage-related securities; these are very limited , however, and , in combination , cannot exceed 30% of the member institution's capital . Restrictions on the use of housing production loans and residential real estate related participation interests as collateral for FHLBank advances should be removed . In fact, all residential-related collateral should be eligible to secure Federal Home Loan Bank advances. EQUITABLE ACCESS TO ADVANCES BY NONTHRIFT MEMBERS The Federal Home Loan Bank Act (FHLBA) establishes a maximum borrowing limit for all members of twenty times the amount of FHLB stock owned by the member. However, access to advances by nonthrift members is actually curtailed by a subsequent provision , which imposes different borrowing limits tied to the level of the Qualified Thrift Lender (QTL) test that thrifts must meet as part of their charter requirements. Thus, while QTL thrifts may borrow $ 20 per $ 1 of stock owned , 6 142 nonthrifts (which almost by definition will not meet the QTL) may borrow only at ratio that declines significantly in proportion to the size of their actual mortgage asset portfolio. For example , a bank that has 10 % of its assets in mortgages can borrow only $2 for every $ 1 of stock owned . This inequity makes it more costly for banks and credit unions to use the FHLB System as active borrowers . Thus nonthrift members may not avail themselves of the special Community Investment and Affordable Housing Program advances to the same extent that thrift members can . MEMBERSHIP IN THE FHLB SYSTEM If the FHLB system is to be a true credit support system for housing , rather than just for thrifts, then membership should be opened , on equivalent terms , to all depository and nondepository lending institutions with a residential housing finance focus. Such members would include mortgage banking companies, state and local housing finance agencies, pension funds and housing- related lending affiliates of insured depository institutions . (The FHLB System has been open to life insurance companies since its inception . ) Transition to an entirely voluntary membership system will be necessary for the FHLB System to serve as a comprehensive credit support mechanism for housing over time. Currently, most savings and loan associations are required to be members, but non-thrift membership is voluntary. The change to universal voluntary membership must be accompanied by a transition process that will assure financial soundness for the System and be fair to all members. THE FHLB SYSTEM PROVIDES INSTITUTIONAL SUPPORT FOR COMMUNITY DEVELOPMENT BANKS The South Shore Bank of Chicago has a membership application pending before the Federal Home Loan Bank of Chicago . NAHB applauds this step to join the System . The policy objectives of the FHLB System and community development banks are consistent in that lending activities focus on housing and community revitalization . A nation- wide network of community development banks, as envisioned by the Clinton Administration , could be sustained and enhanced by the FHLB System . The FHLB System offers services and programs that would potentially buttress the endeavors of community development banks. The FHLBanks are currently active in low- and moderate- income housing initiatives through special , below- market lending to member institutions under their Affordable Housing Program (AHP) and Community Investment Program (CIP) . The latter program is also directed toward small business and community revitalization . Such pursuits are a natural adjunct to the activities of " community development banks " , and the ability of both entities to leverage their funds should be enhanced by their working together. 7 143 The existing institutional framework of FHLBanks would provide other benefits to "community development banks" such as ready access to capital markets at very favorable rates which could be passed on to " community development banks". Also, the regional network of FHLBanks could provide technical assistance and services to "community development banks" and serve as an information clearing house for loan participants as well as provide a secondary market for community development loans. RECOMMENDED LEGISLATIVE MODIFICATIONS TO ALLOW THE FHLB SYSTEM TO SUPPORT COMMUNITY DEVELOPMENT BANKS In order to allow all community-based lenders, including " community development banks " to derive the benefits of the FHLBank System , legislation is required . First, Congress should expand FHLBank authority to invest in participation interests in residential construction loans originated by their member institutions, and to provide credit enhancements for any such interests that they resell . Second, Congress should expand the types of residential assets that may be used without restriction to collateralize advances to include residential real estate-related participation interests, residential production loans, and other types of mortgagerelated securities. Third, the current disparity between the borrowing requirements for nonthrift institutions and thrifts should be eliminated . Currently, nonthrift institutions, including community development banks, are at a competitive disadvantage with respect to their access to advances , including those made under the Community Investment and Affordable Housing Programs. Finally, authority to broaden membership in the FHLB System is necessary to include all lenders with a housing focus. NAHB was pleased to see two important provisions included in S. 265, the Economic Growth and Regulatory Paperwork Reduction Act of 1993 , recently introduced by Senators Shelby, Inouye, Wallop, Mack, and Heflin . A House of Representatives counterpart will be introduced shortly. The provisions included in S. 265 would permit member institutions to use housing production loans to collateralize advances and authorize FHLBanks to invest in loan participations in residential construction loans made by their member institutions. 8 144 Economic Impact of Construction of One Single Family Unit Characteristics of Individual Unit: Equivalent to Median Priced Unit: Less: Value of Raw (Undeveloped) Land Equals: Base for Multiplier Calculation Times: One Year Multiplier (1 ) Equals: Income Multiplier National Local $120,000 ($15.200) $104,800 $76,744 1.98 1.45 $207.600 $111,300 National Labor Years Wages 0.235 $6,110 0.525 $13.650 0.102 $2.652 Wage Impact: Land Development On Site Construction Off Site Construction Other Industries: Manufacturing Wholesale Trade , Transportation , and Services Mining and All Other Total Tax Impact: Federal Personal Income Tax Social Security Tax State Personal Income Tax Federal Corporate Income Tax Local Real Estate Tax Total (1 ) Laurence H. Meyer and Associates 9 Local Wages $6,110 $13,650 $2,387 0.397 $10,322 $4,129 0.355 0.145 1.759 $9.230 $3.770 $45.734 $6,461 $754 $33,491 National $9.604 $1,829 $1.329 $3.690 $1 597 S13.049 Local $1.597 $1.597 145 Direct and Multiplier Impact of Home Construction The estimates of labor requirements included in this table were developed by the Bureau of Labor Statistics ' and have been updated to recognize current wage levels and prices . We estimate that the construction of a median-priced single- family house with a median size of 1,890 square feet directly generates 1.759 work-years of employment in construction and related industries . Construction employment accounts for .627 work-years , land development for .235 work-years , and other industries for .897 work- years . Based on the average wages for these industries in 1990 , this employment impact translates into an additional $ 45,700 in wages and $ 18,800 of tax revenues at all levels of government . The top panel of this table calculates the full economic impact of the increase in residential construction . The impact is calculated by applying a consumption multiplier to the adjusted median sales value of a single- family unit . The item " multiplier" is used to reflect secondary economic effects , primarily affecting consumption , over and above the direct impact on income of home construction . For example , construction workers purchase goods at local stores , and the stores step up hiring and purchases which creates a " multiple " of the original stimulus . Eventually the stimulant declines unless continually renewed . The stimulant resulting from the multiplier is greater in the earlier periods since the stimulant " leaks " away . A recent study by Price Waterhouse , conducted on behalf of The National 2 Association of Realtors , suggests that the first - year consumption multiplier substantially varies based on the economic model employed . The model of Laurence H. Meyer and Associates is used by NAHB for economic and housing forecasts . The first - year multiplier impact , assuming that interest rates are held constant , is 1.98 in the Meyer model and we have applied that multiplier to the median housing unit after adjustment for the value of raw land . The local impact that appears in the right hand column adjusts the national impact since some of the direct labor and materials are purchased from other regions and therefore do not directly benefit the local economy . The multiplier effects are also adjusted to reflect the import of " imports " from other regions . Robert Ball , "Employment Created By Expenditure , " Monthly Labor Review , December 1981 . Construction 2 Price Waterhouse , Contribution of Single - Family Home Resales to the U.S. Economy . Prepared for the National Association of Realtors 1992 . 10 146 BANKING ON COMMUNITIES: DEVELOPMENT BANKING IN THE UNITED STATES (Working Paper) By Kathryn Tholin February, 1993 Woodstock Institute, 407 S. Dearborn, Chicago , IL 60605 (312) 427-8070 147 The Woodstock Institute The Woodstock Institute is a not-for-profit organization based in Chicago. For the past twenty years, the Institute has carried out applied research and " developed and implemented programs which increase private sector investment in modest-income and minority communities for the benefit ofthose who live there. It designs programs which bridge the gap between the needs of communities and the resources of banks, savings and loan associations, foundations, and others. The Institute provides a variety of services to community- based organizations, financial institutions, foundations, and government agencies, including applied research, policy analysis, program design, and evaluation. Malcolm Bush President Kathy Tholin Executive Vice President Ernestine Jackson Vice President 148 ACKNOWLEDGEMENTS The Institute would like to thank those individuals who contributed to this report: Jean Pogge, South Shore Bank; Robert Weissbourd, Shorebank Advisory Services; Katherine McKee and Bryan Hassel, Center for Community Self Help. All errors and omissions are the responsibility of the author. This publication is a working paper, written and published by Woodstock Institute. The complete paper will be published in March, 1993, and is the fourth in a series of Woodstock Institute case studies on community development financial institutions. Other titles in this series are: Banking Services for the Poor: Community Development Credit Unions Lenders of First Resort: Community Development Loan Funds The Business of Self-Sufficiency: Microcredit in the United States The Community Development Financial Institution Case Studies were funded by the Ford Foundation. The Community Development Bank study is also supported by The Joyce Foundation. For copies of these publications contact: Woodstock Institute, 407 S. Dearborn, Suite 550, Chicago, Illinois 60605, (312) 427-8070. 149 Table Of Contents Page Section I: Introduction 1 The Need for Credit 33 Community Development Financial Institutions 4 Section II: What Is A Community Development Bank What is a Community Development Bank? Section III: The Current Experience Of Community Development Banks Shorebank Corporation 9 10 23 Center for Community Self-Help 12 Southern Development Bancorporation 13 Section IV: Key Components Of Development Banks 17 Section V: 21 22 Conclusion 17 150 Section I: Introduction In 1985 the Workers Owned Sewing Company (WOSCO) was in trouble. Located in Bertie County, a low-income rural county in Eastern North Carolina, the company's business came from contracts with other apparel companies for their overflow work. This type of business was sporadic, unpredictable , and highly competitive, operating on very thin margins. To grow, the company needed to be able to by-pass the middleman and bid directly to retailers. To do that, however, required credit for necessary materials and supplies. The company had been unable to get credit from its suppliers, and managed its existing business with a $10,000 line ofcredit from a small local bank. The local bank, however, was purchased by a large regional bank, which cut off the company's line of credit. Without a new source of credit, the company would not be able to continue its current work, let alone expand. With no other prospects for credit, WOSCO turned to the Center for Community Self- Help , which had been providing technical assistance to the company for several years. Through its credit union and ventures fund, Self-Help made the company a $50,000 loan. They also continued to provide assistance in the areas of marketing , financial management, business planning , and staff development. Once the first loan was paid off, the Center continued to provide working capital loans to the company. Today WOSCO, with 80 workers, is the second largest employer in its county. Seventy percent of its work is now direct contracts with retailers rather than other manufacturers. It has secured contracts with Sears and K-Mart as well as a regional department store chain. The company increased its sales from $760,000 in 1985 to $ 1.8 million in 1992. At the end of 1990, the company was able to distribute $27,000 in profits to its workers, who are also its owners. In Chicago's South Shore community, Vivian Wilson's $1 million city contract to provide security services almost cost her 70-year old company when the city's slow payments exhausted her operating reserves. When her bank wouldn't make her a loan, and she was within two week of running out of cash, she turned to South Shore Bank. Ms. Wilson did not have the personal assets banks usually require an applicant to pledge for such a loan. South Shore Bank lending officers , however, were impressed by her business management, believed she would be able to deal with the city bureaucracy, and went to work to structure a loan. In two weeks, the bank was able to package a $250,000 line of credit that was partially secured by an apartment building owned by Ms. Wilson, with half the loan Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 151 Page 2 guaranteed by a fund established by a purchasing managers ' group to help minority-owned businesses. The bank's commitment to move quickly, willingness to work with external credit-enhancement programs, and ability to spend the time to package a deal that was good for both the bank and the applicant meant that Ms. Wilson was able to make payroll and keep her business operating. The institutions that made these loans were not ordinary financial institutions. These are institutions that have staked their claim in markets that • are not seen as desirable and borrowers that are often not seen as creditworthy by ⚫ conventional financial institutions. They are among a small number ofdepository institutions organized both to address the credit needs of disadvantaged communities and to have a lasting impact on the development of those communities, the growth of local economies, and opportunities for advancement and economic security for low and moderate income individuals and families. While today there are only a handful of community development banks in the United States, these institutions are demonstrating that a development bank can be a powerful tool for building communities and strengthening local economies. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 152 Page 3 Section II: What Is A Community Development Bank? The Need for Credit Urban and rural community development practitioners have demonstrated that access to capital and credit is critical to revitalizing housing and creating and retaining jobs in disadvantaged communities. These communities may be inner city neighborhoods, low-income rural areas, or particular groups of people (women, minorities, low income families) across several geographic communities. One way to see the critical role of credit is to look at a disinvested community--that is, a community in which credit has stopped flowing. When credit is not available for everyday community investment needs, the local economy starts to fall apart at the seams. Buildings deteriorate when rehabilitation funds are unavailable; housing values decline if buyers can't find mortgages; modest income people can't purchase a home; businesses stagnate or relocate when they can't get loans to expand or modernize. Disinvestment ultimately destroys the economic assets of a community. When it is available, however, credit serves as a catalyst for investment in a community. the extension of credit by a financial institution is viewed by others as an expression of confidence in the future of that community. Loans to housing and economic development projects result in visible improvements which become symbols of community improvements. The availability of credit has a multiplier effect, leading to additional investment by developers, other financial institutions, and homeowners, landlords, and business people within the neighborhood. Credit gaps exist when lenders perceive particular markets or borrowers as entailing higher risks or lower returns than other types of lending or when racial or cultural barriers interfere with lending judgments. Such perceptions have resulted in the disinvestment of entire communities, but they have also resulted in a lack of available credit to lower income homebuyers, minority borrowers, small businesses, and other types of unconventional borrowers. Financial institution consolidation and increasing standardization of loan products further constrains the availability of credit and the possibilities of economic development for distressed communities and individuals. While conventional credit can keep a healthy economy working , rebuilding a deteriorated economy or making loans to people who have historically not had access to credit requires more than conventional lending techniques. Borrowers need more assistance, projects may need unconventional terms. These borrowers and communities need lending institutions that understand local credit needs , have Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 153 Page 4 a commitment to community economic development, and have underwriting standards that address local market realities. Perhaps most important, they need institutions with an array of financial and non-financial interventions that reinforce each other and rebuild or strengthen a local economy. Community Development Financial Institutions Over the last two decades a range of types of community development financial institutions have developed to address the need for equal access to traditional credit and the need for development credit. Beginning as individual experiments in local areas across the country, these institutions have become an emerging community development industry. They include community development banks, community development credit unions, and community development loan funds. In some cases these institutions are defined with a broad economic development focus, in others they are narrowly focused on delivery of a small number of development credit products. Community development financial institutions share several common characteristics: They are organized to serve economically distressed communities They serve a targeted geographic area or sometimes a targeted constituency They have as their primary mission the development of communities and their residents, utilizing the provision of credit and other development activities as a means to achieve that mission. They fill credit and in some cases financial services gaps that are not met by traditional financial institutions. Earlier Woodstock Institute publications have examined in detail the work of community development credit unions, community development loan funds, and microenterprise funds. This paper provides a definition and overview of community development banks. What is a Community Development Bank? A community development bank is the most broadly defined, and potentially the most comprehensive, of the community development financial institution Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 154 Page 5 models. While other community development financial institutions tend to specialize in a particular type of product or credit activity, a community development bank can incorporate both a range of lending services and a broader range of development-oriented activities. · A community development bank is a community development institution that utilizes a commercial bank, credit union, or savings and loan as a vehicle for providing development credit for a targeted community or population, and which has proactive, development-oriented subsidiaries and affiliates. Community development banks are the most extensive and best capitalized type of community development financial institution. The depository institutions of community development banks are chartered, regulated, and able to engage in the same types of business as their conventional commercial financial institution counterparts. A community development bank is distinguished from a traditional bank, however, in two fundamental ways . First, a development bank has chosen as its primary corporate mission the comprehensive development of a community or communities , not the provision of credit and financial services . Second , a development bank is based on an understanding that access to credit alone can not revitalize a distressed economy; that additional development activities and efforts are necessary to promote economic activity in disinvested communities. Mission A community development bank, like any financial institution , must be concerned about the sound operation of a regulated financial institution. While operating a sound and successful financial institution is essential for the success of a development bank, the primary goal is focused on the impact that institution, and its other activities, have on the institution's targeted community(ies). A development bank has a dual standard of performance; it must successfully operate a financial institution , and it must foster community development and renewal. Ultimately, a community development bank seeks to demonstrate that these are not inconsistent goals. Additional Development Activities A regulated financial institution is limited in its ability to have a significant community development impact through credit alone. A development bank has targeted communities and populations with needs that go beyond traditional credit. A bank's lending is constrained by regulatory standards designed to protect depositors and the public from losses. While a bank is not simply a passive actor, a conventional financial institution cannot easily play a proactive development role in a community. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 155 Page 6 For example, a bank can declare its willingness to make multifamily building rehabilitation loans in a particular area. It can market this product aggressively in this area. But it cannot on its own purchase and rehab the big abandoned building on the corner, even though this would give other investors the confidence to invest in surrounding buildings. A bank can make loans to small businesses in its area, but it can't make the equity investments needed to start new businesses, and it can't provide the training and job placement services to help ensure that local residents get the jobs created through expanded business activity. Without an approach which incorporates some of these types of activities , a bank may make some loans, but not have a long term impact on the overall development of a community or targeted area. This blend of activities and goals means that a development bank combines the structure and expertise of a for-profit financial institution with the commitment to people and to place one normally sees in community-based non-profit organizations. Structure A full-fledged development bank is formed by a holding company or parent organization which owns (or, in the case of a credit union, operates) an insured depository institution , and has subsidiaries and/or affiliate organizations which can supplement the bank's lending with technical assistance, direct community development activities, and/or higher risk or more flexible financing. The community development bank is able to utilize a depository institution to channel ordinary deposits into community development lending . The subsidiaries and affiliates allow the development bank to move beyond the limits ofa bank structure , address deeper credit needs , make higher risk investments, and more proactively address a broader range of community development needs. Affiliated development activities are determined by the mission of the institution, and the particular needs of its targeted communities. They may range from enterprises designed to provide equity financing to small businesses or real estate development companies to efforts to provide education and job training to community residents. Their purpose is to build capacity and resources within the targeted community or constituency. Through their ability to use the lending and deposit gathering properties of insured depository institutions and the proactive community development Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 70-832 0 - 93 - 6 156 Page properties of various types of subsidiaries , development banks can implement a broad economic development strategy and achieve a critical scale of impact in a targeted area or with targeted populations. One primary premise of a development bank is that mobilizing a large volume ofcapital for development lending is key to the revitalization of a particular community/geographic area and the reestablishment of market forces to sustain the community and its residents. The sum total of these activities, both the regulated financial institution and its affiliated activities, is the development bank. There are only a few full-fledged development banks operating in the country today. Shorebank Corporation, which owns South Shore Bank in Chicago, and Southern Development Bankcorporation, which owns Elk Horn Bank and Trust in Arkadelphia, Arkansas, are the two largest development bank models. Self-Help Credit Union, operated by the Center for Community Self-Help in Durham, North Carolina, is also organized on the development bank model. Community Capital Bank in Brooklyn is the newest of the development banks. It is not currently organized on the holding company model, but has established affiliated community development activities. The three oldest community development banks are profiled in the following section. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 157 Page 2 Section III: The Current Experience Of Commmunity Development Banks Each existing community development bank has a unique story. For a development bank, location dictates design. Each community development bank has chosen its specific focus and market based on the needs of the community it seeks to serve. The existing development banks have chosen different development strategies and developed differing types of lending and development expertise. South Shore Bank's largest concentration is in housing purchase and rehabilitation loans , particularly for multifamily buildings . Southern Development Bankcorporation's mission is to catalyze economic development in a rural area through financing for small, locally-owned businesses. The Self-Help Credit Union focuses on business development and homeownership lending. The three institutions profiled here have these key features in common: A holding company or parent organization owns or operates (as legally appropriate in each instance) the financial institution. This means that the corporation's overall vision is held outside as well as within the financial institution itself. While this may not be essential to a community development bank model, it helps to ensure the financial institution's long term accountability to the community development mission , despite the pressures of operating a sound financial institution. The umbrella structure enables the coordination of multiple efforts towards the same goals. Each institution has multiple strategies for community development. This is true both within the financial institution subsidiary, where different types of loan programs have been developed, and in affiliated non-bank development activities. The development banks have chosen their lending markets and their development activities based on an assessment of the specific needs of their targeted area and constituencies. Based on the particular needs of their targeted communities, these three development banks have very different lending strategies and different configuration of nonlending development programs. The institutions seek to capitalize on the synergies made possible through the combination of their lending and development activities. Both are designed to reinforce each other in building local markets and capacities. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 158 Page The holding companies reinvest a portion of the return on revenuegenerating activities into other areas of their activity that require capitalization or development funds. The banks have evolved their current focus and activities over time as they develop new programs and build their capacities, as their knowledge and understanding of their target communities and constituency deepens, and as their development activities themselves generate new opportunities for lending. Shorebank Corporation The oldest and best known community development bank, Shorebank Corporation was formed in 1973, when a small group of investors purchased a troubled bank in a rapidly deteriorating inner-city neighborhood that had changed from 90 percent white to 90 percent black in ten years. The flight of white residents was accompanied by a flight of capital; banks redlined the area, landlords stopped maintaining apartment buildings, store owners stopped improving their businesses, people stopped upgrading their homes, and the community entered a spiral of economic and physical decline. Shorebank's founders, four bankers working in an adjacent , stable neighborhood, formed a holding company and purchased South Shore Bank. The community's last locally-based bank, South Shore Bank, had quit lending in the area and its owners had unsuccessfully sought regulatory permission to relocate downtown. The new owners set out to demonstrate that a regulated bank holding company could serve as a vehicle to reach a scale of investment and targeted activities which could stabilize and revitalize a community suffering from disinvestment. Barely able to raise enough capital from investors who shared this untried vision, Shorebank began with the operation of the bank alone. Five years later, in 1978 , it was able to raise additional capital to create two other for- profit subsidiaries and one non-profit affiliate. Since 1985 it has added three additional subsidiaries and affiliates. Shorebank's affiliates and subsidiaries provide a multifaceted package of development components. South Shore Bank is a full-service commercial bank offering both commercial and residential loans. City Lands Corporation is Shorebank's real estate development company. It develops and manages residential and commercial real estate for the benefit of low and moderate income residents. It can target key anchor properties for development, opening the market to more conventional investors who can receive financing from the bank to rehab smaller properties nearby. The Neighborhood Fund is an SBA-licensed Minority Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 159 Faze Enterprise Small Business Investment Corporation, which finances businesses with equity investments and long-term subordinated debt. The Neighborhood Institute (TNI) is a nonprofit, exempt affiliate of the holding company. TNI focuses on human development as well as housing development. TNI operates GED and job training programs , job placement programs , and manages three small business incubators . It also includes community organizing, cultural activities, and senior services. TNI Development Corporation, its for-profit subsidiary, develops rental and cooperative housing for low income residents. Shorebank Advisory Services is a consulting firm that offers technical assistance nationwide on development banking and other community economic development strategies. In addition , Shorebank expanded in 1992 by establishing two business development affiliates, which, combined with the loan production office of the bank, will be providing lending and services in the Upper Peninsula of Michigan. South Shore Bank itself makes both housing and business loans, but it is the bank's unique approach to lending for multifamily purchase and rehabilitation that has had the greatest impact on the community. The bank has successfully fostered a large group of small-scale rehabbers who rehab , hold , and manage 24-36 unit apartment buildings. In making these loans, the bank focuses on market and character judgments more than on standard ratios--is the borrower paying a fair price, can he/she stretch a rehab dollar, manage the building, deal with tenant problems? All the bank's mortgages include rehabilitation . The bank's detailed market knowledge , its status as the primary lender in this market, and its commitment to say no to deals where the purchase price, rehab costs, or the afterrehab rents are too high means it has been able to significantly improve the housing stock without gentrifying the neighborhood. Since 1973, the holding company has made $ 340 million in development financing. It has financed purchase and/or rehabilitation of more than 30 percent of all housing units in South Shore. At the end of 1992, it had $55 million in business loans. The bank has grown from $40 million to $211 million in deposits, 55 percent of which come from depositors outside the South Shore community who support the bank's development efforts. The bank itself has operated at a profit every year since 1975. In 1991 alone, the bank's development subsidiaries rehabilitated more than 1400 units of housing, and placed hundreds of residents in jobs. In 1986, the bank expanded its lending operations into Austin, a west side Chicago neighborhood suffering from longer-term disinvestment and deterioration. Most importantly, Shorebank has stabilized the economy of South Shore, created dramatic improvements in the quality of housing, brought in new business Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 160 Page activity, and instilled a new outlook on the neighborhood by both residents and outsiders. While operating successfully and profitably, Shorebank has had to rely on patient investors willing to see profits reinvested in bank expansion and in subsidiary operations. In 20 years, its common stock investors have not received a dividend. The value of their investment, however, has grown at an average annual rate of 16.5 percent. Shorebank's investors include foundations, religious institutions and a number of individuals. Shorebank managers know their package works, but are the first to point out that their specific formula won't work everywhere. " Our organization...is not a cure-all for the most depressed places in America", says Ron Grzywinski, a founder ofthe bank and chairman of Shorebank Corporation. "Our strategy relies on being able to cultivate a group of private individuals who are working in their own selfinterest, which happens to be the best interest of the community. " Shorebank has successfully targeted the development needs and opportunities of its particular community. The interventions and development activities it chose have had a substantial impact. Center for Community Self-Help In 1984, the Center for Community Self-Help, a four-year-old nonprofit organization working to create economic opportunity for disadvantaged North Carolinians, formed the Self-Help Credit Union. Starting with $77 raised at a bake sale, Self-Help has grown to more than $40 million in assets , becoming the nation's first statewide community development bank. Self-Help's development strategies have targeted the creation of affordable housing opportunities; assistance to women- and minority-owned enterprises, especially in rural areas of the state; facilities development for nonprofits serving low income and special needs families; and promotion of statewide programs by both public bodies and private financial institutions to create development lending programs on a broader scale. The Center has developed an integrated set of tools to address this range of development activities. The Center began its work in 1980 offering technical and managerial assistance to struggling small businesses in the state. After four years it concluded that it needed to provide access to capital as well, and in 1984 created two lending vehicles--Self-Help Credit Union, a regulated depository institution, and Self-Help Ventures Fund, a nonprofit revolving loan fund. Self-Help Credit Union is the banking center of the Center for Community Self-Help. Self-Help Credit Union is a state-chartered, federally insured credit Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 2 161 Page union, whose membership is open to all members of the Center for Community SelfHelp. The credit union limits its lending to the state of North Carolina. The credit union's main office is in Durham, with branches in Asheville, Charlotte, and Greenville. Unlike most credit unions, Self-Help Credit Union does not see retail services as key to its mission. Instead, the credit union's primary function is as a proactive lender gathering capital from supportive depositors across the country to use for loans. As a result, the credit union offers only basic savings and checking accounts (called share accounts and share draft accounts in a credit union) , does not provide cash transactions, and does not place a priority on offering the highest possible rates to attract depositors. Self-Help's nonprofit loan fund allows it to extend credit that would not meet the regulatory standards of the credit union. It attracts investments from sociallyoriented investors both within and outside of North Carolina. Its investments , unlike the credit union's deposits, are not insured. The parent organization for Self-Help engages in non-financial activities which address its overall mission. These include extensive educational and technical assistance to borrowers, development of new lending programs which it promotes with other lending institutions and public bodies, and training for loan officers in conventional banks, among others. Though very small by conventional financial institution standards, Self-Help has grown rapidly to a level where it is able to have a substantial development lending impact. By the end of 1992, Self-Help development bank made a total of $40 million in loans, and is poised to make at least $12 million in additional loans per year. It has made more than 450 mortgages for first-time homeowners who were unable to receive conventional mortgages, predominately single minority female heads of households. Self-Help piloted an innovative mortgage product, with low down payments and relaxed debt-to-income requirements, which Fannie Mae now offers nationwide. In Charlotte, more than 125 public housing residents became homeowners through Self-Help programs. Self-Help's 1992 business lending provided loans for 138 small enterprises, with loans ranging from a few hundred dollars to several hundred thousand dollars. Self- Help now manages government-funded pools of capital from state and federal programs. It also provides small loans to day care providers to enable startup and expansion of child care services. The loan fund's microenterprise program provides loans to very small, often home-based businesses. Despite its exclusive focus on borrowers who are unable to access conventional credit, Self-Help's lending has performed extraordinarily well. In 1991 , the credit union averaged one percent delinquency, less than the industry average. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 162 Page Average annual losses have been less than 0.1 percent of average annual outstanding loans. Southern Development Bancorporation Southern Development Bancorporation was established to address the economic development needs of rural Arkansas. Southern's mission is to stimulate and expand the regional economy for the benefit of low and moderate income residents by assisting people to establish and expand locally owned small businesses. Organized on the South Shore Bank holding company model , Southern was established by 26 private, public, and non-profit investors, led by the Winthrop Rockefeller Foundation in Arkansas. Southern began operations in 1988 with the acquisition of the Elk Horn Bank and Trust Company in Arkadelphia, Arkansas. Like Shorebank and the Center for Community Self-Help, Southern utilizes for-profit and nonprofit, financial and nonfinancial vehicles to address its business development mission. Southern's affiliates and subsidiaries assist enterprises ranging from microenterprises employing only the owner to a company employing 165 people. There are five components of Southern's development bank. Elk Horn Bank and Trust is a regulated commercial bank which makes consumer, residential, and business loans. Elk Horn's "development loans” are business loans which would not be made on similar rates and terms by other banks. Opportunity Lands Corporation is a developer of commercial and residential real estate. Three components are grouped together within the Arkansas Enterprise Group, a nonprofit affiliate of Southern. Southern Ventures , Inc. is a small business investment company licensed by the SBA. It is the only active venture capital company in Arkansas for investments of $50,000-$250,000. The Good Faith Fund is a microenterprise loan fund inspired by the Grameen Bank of Bangladesh. It provides extensive technical assistance and very small loans ($1000 average) to low income individual entrepreneurs. AEG Manufacturing Services provides nonbank financing (long term loans, leases on equipment, and working capital), as well as financial consulting, market assistance,and accounting services for small manufacturers. Southern managers believe that it is critical to provide a range of development resources for rural enterprises in order both to be successful with individual companies and to improve the local economy. They also believe that it is critical to provide these services for several levels of enterprise--from individual microentrepreneur to medium-sized firms. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 163 Page Between May, 1988 and June, 1992, the Southern companies have extended over $14 million in development investments in 145 enterprises and family farms in rural Arkansas. (This does not include the conventional lending activities of Elk Horn Bank.) Slightly more than half of the borrower businesses are minority owned. The bank has lost less than one percent on the development loans it has originated, and delinquency rates are below the industry-wide rates. Losses in the nonregulated components ofthe development bank are somewhat higher, but in line with expectations for these more risky loans . From 1989-1992, Southern has earned at or above the industry bench mark of one percent return on assets. Southern's integrated approach to business development has demonstrated benefits in individual companies. Only in operation for four years, Southern cannot yet measure its impact on the overall economy of rural southern Arkansas . Ultimately Southern will measure its success on the extent to which it is able to create jobs , diversify the economy and ownership of wealth , build stronger companies, increase exports and decrease imports into the local economy over the long term. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 164 Page Section IV: Key Components Of Development Banks Each of these institutional models share a number of common components and structural characteristics. Each of these common characteristics play a crucial role in the success and the impact ofthe overall enterprise. · For these three institutions, the holding company is the creative center of the model (in the case ofthe Center for Community Self-Help, the 'holding company' is the parent nonprofit organization) . It coordinates and manages the activities of the overall enterprise. It is the place where the institution's overall community development mission is formulated and redefined. As the umbrella structure of the development bank, the holding company has responsibility for business planning's strategic planning and development for the depository institution and other subsidiaries or affiliates. It seeks to coordinate the work of the various components of the institution, both with each other and the overall mission. It reviews and evaluates the work of the institution and its impact on its targeted communities. Another key responsibility ofthe development bank holding company is fundraising: primarily the raising of investment capital for the bank models, or in the case of the Self- Help model , the raising of funds for operations, capital grants, and social investments. The holding company or parent is also likely to be the mouthpiece for the organization, telling the story of the institution and its work to a broader audience. In the case of Self-Help, the parent organization also directly operates the development bank's non-financial programs. In addition, the parent organization advocates for increased resources and supportive policy and regulation for the types of programs it has implemented, both from state government and from conventional financial institutions. The insured depository institution is the economic engine which grounds the development lending and financial services of the development banking operation. There are several attributes of a depository institution which make it a strong tool for community development. Depository institutions are Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 165 Page known and trusted models. The actual presence of a financial institution can increase community confidence in a disinvested community. And , a regulated depository institution can convert ordinary individual and institutional deposits into development lending. This ability to utilize ordinary deposits can provide a development bank with access to capital from outside, as well as within, its targeted lending area, and provides access to deposits which would not otherwise be available for this purpose. Using a regulated financial institution as a community development vehicle requires a market discipline not usually found in a community development institution. Community development bank organizers feel that this is an important aspect of their operation. The bank (or credit union) must safeguard its depositors' money, make sound loans, and be profitable. It must submit to regular examinations and keep its performance in line with other banks and credit unions. The profitable operation of the banking institution is what enables the development bank to be self-sustaining and to expand. In addition, its presence in a community itself develops confidence in the community, and sends a message that the community is worth doing business in. Because a development bank's primary mission is community development, however, it does not seek to maximize profits for its investors (or income for its members, in the case of a credit union). A development bank utilizing a for- profit holding company structure seeks investors willing to see the profits from bank operations partially reinvested in subsidiary and affiliate operations. A development bank utilizing a nonprofit depository institution seeks low cost deposits and grants to capitalize its operations and reinvests net income in its development programs. As these examples show, the insured depository institution can be either a bank or a credit union. It could also be a savings and loan or mutual savings bank, although none of the existing development banks are organized in that way. The permitted activities and operating requirements differ somewhat between these types of institutions, and each one brings both opportunities for and restrictions on development lending activities. Credit unions and savings and loans , for example, operate under more restrictions on business lending activities than banks. The reduced capital requirements for starting a credit union,however, mean that they are sustainable at a smaller scale than banks, and are therefore more suited for making very small loans or marketing to smaller depositors . The development mission ofthe institution, available resources , and specific local opportunities determine the most appropriate or feasible model in a given situation. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 3 166 Page As the examples in this paper indicate, while the availability of credit is necessary for a healthy local economy, the existence of credit in and of itself has a very limited development impact. In these institutions, the proactive affiliates and subsidiaries play several essentia! development roles: They allow the institution to develop new lending, capacity building, or technical assistance programs to address community development needs. The affiliates and subsidiaries are the development vehicles for making deals happen. The development corporation can proactively create and help implement new development projects. A bank alone cannot play these roles. They can mobilize existing sources of subsidies available from public and private sources to make sure that programs and projects can serve their targeted constituencies. They are the vehicles for leveraging grant support for nonprofitable development activities and expansion into new programs which may eventually be profitable. In addition to grants, the nonprofit arms of development banks are attractive vehicles for contributions of real estate, donations of in-kind services, and other resources. They most clearly demonstrate the institution's commitment to its mission to depositors, investors, and contributors All of these roles can be played by for - profit and non - profit development organizations unconnected to a depository institution. The power of a community development bank, however, comes from the combination of the depository and nondepository components. The depository arm can leverage substantial resources through its ability to offer deposit insurance, and , once established, is a selfsustaining institution which can operate without subsidies. This gives the community development bank the potential for considerable scale and impact, as well as the staying power to address access to credit and non-financial assistance. For each of these institutions, targeting lending and other activities ensures that the development bank can have a significant impact in its chosen areas. Targeting provides a means of concentrating investment in a defined area so that its impact can be both measured and felt. It is also a form of specialization which allows the institution to build the detailed market knowledge necessary for successful development Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 167 Page 20 lending. Targeting can be either geographic or focused on particular types of lending or constituencies (e.g. , minority-owned businesses, microenterprise loans). A development bank's specific targeting is a strategic choice governed by location, mission, and available resources. The community development banks profiled here have each taken a somewhat different approach to targeting their development programs. For example, the focused geographic targeting of Shorebank reflects the realities of neighborhood disinvestment patterns in Chicago. The bank's early exclusive focus on South Shore allowed it to concentrate its efforts on its primary goals--stabilizing and improving the housing stock and restoring market forces into a disinvested local economy. The bank has expanded its lending efforts as it determined that it had sufficient resources to have a substantial impact in another neighborhood or lending area. The bank's specialization has given it unique knowledge of its target markets , developed its reputation with potential borrowers, and focused its limited resources for maximum impact. The Center for Community Self-Help, in contrast, has not limited itself to a single geographic area, but has targeted particular lending niches statewide. This strategy has enabled Self-Help to specialize in very specific types of lending while creating necessary economies of scale, as well as to " cross-subsidize" more disbursed and therefore more costly rural lending with loan volume from denser urban markets. In addition, its statewide focus has enabled Self-Help to obtain significant levels of state government support which would not otherwise have been available and to effectively advocate for supportive policies and programs on the state level. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 168 Page Section V: Conclusion The experience of these institutions over the past 20 years has demonstrated that well-managed, adequately supported community development banks can successfully provide credit to address specific types of community development needs which have been neglected by traditional financial institutions. They have created and defined a new type of financial institution : a private, profitable, public purpose institution. The experience to date has demonstrated: A community development bank can have broad economic impact, and under the right conditions has the power to restore a functioning market economy to a disinvested area. Unconventional borrowers can be creditworthy --a community development bank can target its lending to disadvantaged communities and borrowers without access to conventional financing while meeting or exceeding industry loan performance standards. A community development bank can be operated profitably, and be a self-sustaining institution able to deliver services over the long term in its target markets. Successful development banks require a clear understanding or local community development needs , a variety of tools to meet those needs, and creative approaches to filling credit gaps not being met by conventional financial institutions. Notwithstanding the successes of existing community development banks, these institutions face enormous challenges in startup and operation . The existence of only a handful of community development banks twenty years after the establishment of the first successful model is testimony to the difficulties . Those banks now in operation have built up to their existing capacities through careful, incremental growth over an extended period. While the growth of a community development banking industry depends on many factors, three stand out as the most critical: 1. Capital for startup and expansion. The availability of capital is the greatest economic barrier to the establishment and growth of Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 169 Page 22 community development banks. Community development banks require long-term, patient investors to enable startup and expansion. Because investments in community development banks have not been structured to maximize or provide market returns, the availability of capital has been limited and therefore limited the expansion or replication of development banks. A strong capital position also allows a community development bank to grow and engage in more development activities . The most recent start-up community development bank, Community Capital Bank in Brooklyn, required $6 million to capitalize the bank alone. 2. Long-term or stable deposits. A stable deposit base is important to · community development financial institutions. It enables long-term or fixed-rate lending, particularly when no secondary market is available. In some cases, lower cost deposits allow particular lending programs or products which can target special financing needs. 3. Management development. Community development banks require financial expertise, management skills , understanding of community development needs, and creative, financially sound approaches to addressing those needs. While conventional banks and community development institutions develop persons with specialized skills in one or more of these areas, this combination of expertise is rare. A major expansion of institutional capacity will require identification and training of a next generation of community development financial institution managers. Woodstock Institute, 407 S. Dearborn, Chicago, IL 60605 (312) 427-8070 170 Statement Francine C. Justa , Ph . Neighborhood Housing Services of February 3 , of D. , Executive Director New York City, Inc. ( NHS - NYC ) 1993 INTRODUCTION : I am pleased to be able to offer testimony to the Senate Committee on Banking, Housing and Urban Affairs . Thank you for this opportunity . My testimony is based on my experiences as the Executive Director of NHS- NYC , a 10- year old community development volume lender operating citywide and in multi - neighborhood settings , a member of the Advisory Board of Community Capital Bank which opened in Brooklyn, NY in January 1991 , and a past faculty member in the Urban Studies Department of Queens College . NEIGHBORHOOD HOUSING SERVICES OF NEW YORK CITY , INC . ( NHS -NYC ) AS A COMMUNITY DEVELOPMENT LENDER : NHS - NYC operates a revolving loan fund for clients who fail to qualify for conventional bank financing . NHS-NYC lends money for rehabilitation to low-and-moderate- income owners of small homes ( 1-4 units ) and to owners of mixed- use and multi - family buildings . We also make emergency loans of up to $ 5,500 within 72 hours to income eligible homeowners citywide . Loans are made at flexible interest rates and terms , based on the borrower's ability to repay . In 1992 NHS- NYC directly lent $4,114,183 by closing 226 loans targeted to the rehabilitation of 477 residential units throughout eligible neighborhoods of New York City . In the 10 years since 1982 NHS - NYC has directly lent over $ 11,500,000 by closing 1,012 loans targeted to the rehabilitation of nearly 2,000 residential units . Our delinquency rate is less than 2 % . we are a lender of last resort helping residents fix their roots , repair a heating system or keep the bathtub from falling through the ceiling . We provide a remedy for the ills of deferred maintenance and we stem the tide of neglect turning credit - starved neighborhoods into neighborhoods of choice . NHS - NYC also purchases , rehabilitates and sells vacant buildings to low and moderate income families . NHS - NYC was a successful co - applicant with the City of New York Department of Housing , Preservation and Development ( HPD ) for a HUD - funded HOPE 3 award to develop 55 single - family homes for low- moderate income first - time homeowners beginning in 1993 . 171 TESTIMONY TO THE SENATE COMITTEE ON BANKING , HOUSING AND URBAN AFFAIRS BY FRANCINE C. JUSTA , Ph . D. PAGE 2 In 1992 NHS-NYC began 2 new programs . One is a homeownership counseling program which will help low- income people establish credit histories and prepare for homeownership. The other is a Foreclosure Prevention Program which will help forestall foreclosure on the homes of low-and -moderate - income homeowners . Both programs rely on partnerships with conventional lending institutions which recognize the ability of NHS- NYC to do outreach and establish trusting relationships with community residents and provide counseling and other assistance in order to qualify them for eventual participation in the conventional market . in 1992 over 200 individuals received these services . Over two thirds of NHS - NYC clients are minority, nearly half are female headed households and nearly one third are elderly . All are low- moderate income individuals who have tried and failed to obtain loans from conventional sources . Our clients require more attention than conventional sources allow for and so help from NHS-NYC is comprehensive . We provide extensive financial counseling to each of our clients . We monitor construction quality throughout the job . We offer intensive , hands - on workshops in topics such as carpentry , electrical wiring or plumbing that meet on a weekly basis . We also offer educational workshops which cover a subject in one presentation discussing issues such as home maintenance , foreclosure prevention , financial management and meeting insurance needs . In 1992 NHS- NYC educational programs reached 1,303 individuals . This type of " full - cycle " lending --- counseling , lending, rehabilitation monitoring and post - purchase education is time consuming and costly . It is also necessary when dealing with individuals and property that have credit issues , title problems , rehabilitation needs , legal entanglement and overall lack of success with conventional credit borrowing . Full -cycle lending is a critical component to a successful community revitalization financing system; NHS -NYC serves this vital niche . NEIGHBORWORKS NETWORK · A NATIONAL COMMUNITY DEVELOPMENT LENDING SYSTEM : part of a national system of community development NHS - NYC is lenders - the NeighborWorks Network - which is monitored by the congressionally - chartered Neighborhood Reinvestment 172 TESTIMONY TO THE SENATE COMMITTEE ON BANKING , HOUSING AND URBAN AFFAIRS BY FRANCINE C. JUSTA , Ph . D. PAGE 3 Corporation . This network , comprised of 180 community - based development organizations , is active in over 150 cities serving 350 neighborhoods containing 4.5 million residents . In 1992 this network directly lent $ 26 million and retained or secured 6,500 affordable residential units . In addition , $ 17.5 million in loans were sold to our national secondary market Neighborhood Housing Services of America ( NHSA ) . Neighborhood Reinvestment provides 2 essential elements to our network . It establishes national standards for the network in the areas of lending, service delivery and financial management . Each NeighborWorks organization is held accountable to these standards . To ensure that the local NeighborWorks organizations are best equipped to meet the needs of their distressed communities , Neighborhood Reinvestment also provides ongoing technical assistance, training and seed capital . These elements provide quality control enabling safe and sound lending practices . The national asset base of the network's local revolving loan funds , seeded by Neighborhood Reinvestment and further capitalized by the private and public sectors , is nearly $ 200 million . The NHSA national secondary market leverages these investments . This secondary market purchases at face value rehab loans and first mortgages for home ownership issued by local NeighborWorks organizations revolving loan funds . NHSA pools the loans and sells securities backed by these loans to private institutional investors at interest rates slightly below market . The cash proceeds from the sale are returned to the local NeighborWorks organization's loan fund , thereby allowing more loans to be made . To date, a cumulative total of $75 million has been purchased . THE IMPORTANCE OF THE COMMUNITY REINVESTMENT ACT ( CRA ) Low and moderate income and minority communities are hurting after years of disinvestment and neglect . People in these communities , working through NHS - NYC , the NeighborWorks Network and other community - based organizations and networks are working hard to improve conditions , but they need the support and cooperation of government and business . In particular , banks and thrifts play a vital role in a community revitalization financing system . Thanks to the Community Reinvestment Act and Congress ' recent improvements to that law , conventional lenders are beginning to play a bigger role in community development efforts . One way that these lenders are becoming more involved is through partnerships with non- conventional community development 173 TESTIMONY TO THE SENATE COMMITTEE ON BANKING , HOUSING AND URBAN AFFAIRS BY FRANCINE C. JUSTA , Ph . D. PAGE 4 lenders such as NHS- NYC and the NeighborWorks Network . During NHS -NYC's early history we only had the capacity to make small loans exclusively with government originated funds . These funds came with target-area and other restrictions and so our ability to make a truly significant impact in Urban Redevelopment was limited . But with a strenghthened CRA, NHS- NYC has been able to leverage private conventional funds for both capital and operating support and has become a truly significant force in the financing and community revitalization of NYC's distressed neighborhoods . Private lenders , encouraged by CRA, realize that through partnership with NHS -NYC loans can be made in markets - both geographic and economic- that they otherwise would not have penetrated , at a cost they can afford . For example , due to CRA, the private dollars invested in NHS-NYC loan pools grew each year between 1989 to 1992 and so did the number of loans made , $ volume lent and units rehabbed . in 1989 , NHS - NYC directly invested $ 648,000 in the rehabilitation of 1-4 family units . These were all government -originated loan funds and they were targeted to 67 projects . In 1990 the direct investment increased to $ 1,256,593 which was targeted to 121 projects . There were some private funds involved in these projects . In 1991 we directly lent $ 1,366,138 targeted to 132 projects ( 208 units ) . This included about 20% private funds . In 1992 , directly as a result of CRA , NHS -NYC invested $4,114,183 targeted to 226 projects (477 units ) ; 48 % of these funds were private dollars reinvested in housing in NYC to individuals with buildings that were turned away by banks . Yet , we have not had $ 1 of private funds default to date ! In addition , NHS - NYC has been able to raise $ 5 million in a line of credit at prime from 13 different conventional lending institutions for a mixed-use and multi - family lending program and another $ 2 million in funds available for loans from 9 wholesale banks which never would have been procured without CRA . The Community Reinvestment Act is making a difference . Even when banks lend NHS - NYC only $ 50,000 we can relend these dollars to 5 to 10 families who may have small repair or emergency needs and not be able to get financing anywhere else . Without the encouragement provided by CRA , our distressed communities would remain credit - starved . 174 TESTIMONY TO THE SENATE COMMITTEE ON BANKING , HOUSING AND URBAN AFFAIRS BY FRANCINE C. JUSTA, Ph . D. PAGE 5 DO WE NEED NEW COMMUNITY DEVELOPMENT BANKS?: There has been considerable talk about the possible creation of up to 100 new community development banks across the nation . Yet, we have across the nation many existing institutions and networks that perform community development lending . There is a significant need to recognize the existence of these entities and properly support them so that they can better fulfill their lending mission . NHS - NYC and the NeighborWorks Network stand as a prime example of non - conventional community development lenders poised to make even greater impacts in the communities we serve if provided proper resources . Other existing institutions that do community development lending include : state - chartered thrifts , S + L's , commercial banks , many with CDC's , ( and among these 106 minority banks ) , church lending organizations , community development credit unions , community development loan funds , micro- enterprise loan funds , city and state lending programs , national intermediaries , program related investments ( PRI's ) by foundations , SBA related lending organizations , social services organizations such as Settlement Housing Funds . What we all need is appropriately priced capital and subsidy funds to support loan originations , financial counseling , rehabilitation assistance , loan servicing and organizational infrastructure ( administration , overhead , space , equipment , training, marketing ) . We do not need another type of institution . The regular banking system already has the means and the obligation to serve all of the community , including minority and low income neighborhoods . While there are some parts of the population where the transaction costs ( outreach, counseling, and other support services ) are so high that loans become unprofitable , as well as continuing systemic racism, there also exists NHS - NYC and the Neighborworks Network , and the institutions noted above with considerable experience and commitment to serving these people . A strenghthened and enforceable CRA encouraging banks to fulfill their community responsibilities through direct lending as well as lending through existing non - conventional lenders ( NHS - NYC et al ) combined with more Federal funds for capital and administrative costs is the most cost - efficient and effective way to develop a community revitalization financing system . 175 TESTIMONY TO THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS BY FRANCINE C. JUSTA , Ph . D. PAGE 6 To the degree that new community development institutions are created, they should only be promoted where it is not possible · to access any existing lending entity . Furthermore , there must be a strong commitment to networking- the goal of moving the urban and rural poor into the economic mainstream requires relationships with mainstream institutions . I have a strong fear that community development banks can become marginal banks for marginalized people and rather than bringing people into the mainstream they will create a separate ( and unequal ) stream. The concept of community development banks, and the role of non-conventional lenders , must go beyond the provision of credit . As we provide financing to distressed areas we need to be considered as stepping stones to the larger conventional banking system which has the responsibility of serving the whole community . SUMMARY: + There are existing systems and channels , such as NHS- NYC and the NeighborWorks Network, as well as other non-conventional lenders that are delivering residential community development loans to bankable and unbankable clients aimed at renewing distressed communities . + There are real costs to originating smaller loans that need to be recovered but can not be absorbed by the loan client . + Existing systems require additional equity , operating support and appropriately priced and flexible capital to meet the needs of marginally bankable clients and the larger unmet market of responsible , yet unbankable clients . + The resources of the non- conventional lenders need to be leveraged by secondary outlets such as NHSA , and the non- conventional lender needs to adhere to high quality standards , both financial and programmatic . + The Community Reinvestment Act and anti -discrimination laws must be strengthened and more effectively and aggressively enforced to encourage broader community lending and possible linkages with non-conventional lenders . + Community development banks should be promoted only in areas where there is no other source of credit available . 176 TESTIMONY TO THE SENATE COMMITTEE ON BANKING , HOUSING AND URBAN AFFAIRS BY FRANCINE C. JUSTA, Ph . D. PAGE 7 SUMMARY CONTINUED Community development banks must be stepping stones to the economic mainstream and not marginalized institutions serving marginalized people . Thank you for the opportunity to submit this testimony. I am available for any follow- up or additional hearings that may be held on the topic of " Urban Redevelopment Initiatives " . Respectfully submitted , Francine C. Juste, Ph . D. Executive Director 177 CFA ConsumerFederation of America STATEMENT OF CONSUMER FEDERATION OF AMERICA before COMMITTER ON BANKING , HOUSING AND URBAN AFFAIRS UNITED STATES SENATE on COMMUNITY DEVELOPMENT BANKING February 16 , 1993 The Consumer Federation of America is pleased to submit this statement for the record on community development banking . CFA would like to commend Chairman Riegle for scheduling hearings on community development banking in the first weeks of the 103rd Congress . The Committee's early focus on the financial needs of distressed communities confirms that community development initiatives will be a top priority of this Congress . Since the founding of the Consumer Federation of America in 1967 , our national , state and local members have been deeply concerned about the availability of financial services for low- and moderate-income consumers . While these consumers , many of whom live in inner-city and depressed rural communities , may not have the vast financial assets that the banking industry is wont to chase , their needs for basic banking services have never been lacking . Tragically, today , millions of households are non-participants in our nation's subsidized , regulated and insured banking system. These consumers strive to make ends meet without benefit of simple checking accounts -- payment mechanisms most Americans take for granted and suffer the debilitating consequences of growing credit famines within their communities . Such exclusion is intolerable and unconscionable under a deposit insurance system that is subsidized and supported by all taxpayers . CFA is concerned that the people least able to pay are required to pay the most in a financial system that sends millions of citizens into the arms of high- priced check cashing operations , loan sharks , pawn shops and money order firms just to meet day-to- 1424 16th Street. N.W.. Suite 604 Washington. D.C. 20036 • (202 ) 387-6121 178 day financial needs . This is a situation that should not be tolerated in a proud nation like ours . However , we are pleased that from the campaign trail there has come a Presidential finding that commercial banks , despite the Community Reinvestment Act , the Fair Housing Act and the Equal Credit Opportunity Act , have left an enormous gap in financial services for millions of Americans in many of our nation's inner cities and rural towns . The President in his campaign , and his advisors since , have talked about the great gulf of credit and banking services that have left deep financial scars on the nation . The President and his advisors have also repeatedly spoken of the dire need for immediate national action to heal these wounds . CFA knows that rehabilitating the Nation's financial wounds will require a concerted and comprehensive effort to ensure that the existing banking system strives to better meet the needs of underserved communities , that Federal credit facilities be upgraded and rallied behind revitalization efforts and that the Nation experiment , as the President has proposed , with non- traditional community development banks to stimulate economic activity and job creation in communities that the banking industry has abandoned at great cost to the Nation . CFA strongly believes that the community development banks that the President has proposed must be a supplement to existing banking facilities for low- and moderate - income and particularly minority consumers and neighborhoods , and not a replacement for the major source of mortgage , consumer and commercial credit -- the nation's commercial banks and savings and loan associations . It is our belief that the President's pledge to create community development banks is rooted in the goal of full - service banking for all Americans . The President's community development bank initiative is an effort to expand financial resources in distressed communities -not an effort to collapse or to replace existing resources . The resources within the banking and thrift industries , credit unions , and Government Sponsored Enterprises like Fannie Mae , Freddie Mac , the Federal Home Loan Bank System and the National Cooperative Bank must continue to be utilized , strengthened and targeted if the problems of these consumers and communities are to be responsibly addressed . This is not a simple task and there are no simple solutions . COMPREHENSIVE APPROACH REQUIRED In order to stimulate the economic revitalization of these distressed communities , CFA believes that a comprehensive approach must be developed . In broad outline , a comprehensive approach will require maximum local flexibility in the utilization of Federal 2 179 resources , the commitment of substantial support for outreach and technical assistance to build capacity among all participants , strict targeting of subsidy monies and the requirement that the full array of existing financial institutions --both public and private -- be called upon to be partners in the effort . The development of a full-service financial infrastructure in these distressed communities will require the that the following minimal actions be taken : 1 ) Mandate Basic Banking and Government Check Cashing . The community development bank initiative must be integrally linked to efforts to provide access to basic banking services for all consumers in the mainstream banking system. This is not too much to ask of an industry subsidized and backed by the taxpayers . Since the deregulation of interest rate controls on deposit accounts beginning in 1980 , US banking institutions have embarked on deliberate strategies of improving their profitability at the expense of consumers and the well -being of local communities by vastly increasing income from fees and charges for banking services . Bank services that used to be free are now honeycombed with fees and those for which there used to be nominal charges have been subjected to substantial and often prohibitive increases . The net result of these changes has been to send millions of lower income and elderly consumers out of the lobby and into a growing market- place of alternative and unregulated high- cost fringe banking . Basic banking is the first step of including the poor , working poor and elderly in the nation's publicly subsidized banking system. A deposit account has important intangible values necessary to conduct day-to-day personal business and to organize a consumers ' financial affairs . It is difficult , if not impossible , to build a credit record -- the key to economic opportunity in our society 88- without a banking account . For consumers , a banking account is more than just getting your check cashed . It is the very means of financial empowerment . 2) Preserve Bank Representation in Low- Income Communities . A bank branch is an integral part of the economic well -being and development of a local community . When a bank branch closes , it is more than an inconvenience -- more than an expense ; a feeling that a community devoid of banking services is a community at risk sets in . When the teller , the loan officer and the branch manger disappear , consumers and small businesses alike assume new costs and new burdens to meet their day-to -day financial needs . Hardly a week goes by today without a major metropolitan newspaper 3 180 chronicling the growing epidemic of bank branch closures in lower income communities . To ensure that there is no further erosion of banking services for consumers and communities that are on the ragged edge , CFA calls for an immediate moratorium on branch closures in low- income communities . A prohibition on branch closures should remain in place until firm policy is in place at regulatory agencies for evaluating claims that there is an economic need to close any existing branch and a system is developed to guarantee the availability of alternative and affordable banking facilities for impacted communities . A solution may involve getting the National Credit Union Administration to determine if a credit union could be established in the community . It may mean working with local governments and agencies to secure municipal deposits and coordinated economic development strategies . But , clearly , we are not being a very imaginative government if we are allowing the loan window to be shut and the branch door to be padlocked without trying to ensure that communities are not cut off from access to basic banking services . 3. Upgrade Existing Federal Credit Programs . Upgrading Federal credit programs and credit institutions that support private sector lending by both for-profit and not- forprofit firms -- like those on the books at the Federal Housing Commission , the Small Business Association , the Economic Development Administration , the Federal Home Loan Bank System, the and the National National Cooperative Bank Credit Union Administration should be integral components of a comprehensive community development banking initiative . For example , as other witnesses have testified , the National Credit Union Administration could enhance its program for the promotion of Community Development Credit Unions to provide needed depository and credit services in many areas . Similarly , the National Cooperative Bank could use its " development window" to provide loans and technical assistance for consumer-owned enterprises ranging from business to housing and health care cooperatives . And , the 12 regional Federal Home Loan Banks have , in addition to being a ready source of below-market funds , considerable technical assistance capabilities that could be utilized to spur economic development through the system's over 3,600 member institutions . 4. Enhance Enforcement of Community Reinvestment and Fair Lending Law No community development initiative can overlook the importance of requiring the regulatory agencies to put special 181 emphasis on examinations , regulations and guidelines that will ensure full enforcement of statutes , such as the Community Reinvestment Act , the Fair Housing Act and the Equal Credit Opportunity Act , which have been placed on the books to promote credit job creation , economic development , fair lending , availability and the provision of banking services to all sectors of the economy . in a Each of these initiatives should be included comprehensive strategy to realize the President's goal of placing these financially distressed communities on sound economic footings . THE PEOPLE IN COMMUNITY DEVELOPMENT BANKS CFA believes that the single most important consideration for the Congress as it molds the President's community development banking initiative is to be guided by the new Administration's motto of " Putting People First " . We recommend that consumers be actively consulted , represented and involved in the development and day-to-day operations of community development banks . The only way community development truly takes hold is when the residents of a community believe they have a real stake in their communities ' growth . There are three key elements to consumer empowerment that should be at the core of a community banking initiative : 1 ) Place real people on the boards of new community development banks . In 1989 , CFA urged that the Congress revitalize the Federal Home Loan Bank System by placing consumer representatives on the board of each Home Loan Bank and that each bank create an advisory council composed of low- income housing advocates and consumers . The Home Loan Bank Affordable Housing Programs are today a model of public-private partnership because these programs have been developed and overseen by these consumer representatives . This successful model of consumer representation should be imported into this Committee's legislative product on community development banks . 2) Provide support for consumer controlled financial institutions . Consumer controlled financial institutions like credit unions and consumer cooperatives are institutions that for years have stabilized the financial health of local communities . Credit unions and cooperatives are the epitome of financial empowerment from the 5 182 ground up . They deserve a significant role in ultimate legislation and should have substantial funds earmarked for their development . 3) Investment in outreach and technical assistance . The importance of technical assistance , including consumer education and counseling cannot be overemphasized . The communities that the President identified as short on capital , credit and banking services are in need of lots of hands on help -- from consumer education on the value of a savings account to how to start a family small business . These elements are critical components community development banking program . of a successful COMMUNITY DEVELOPMENT BANKS AND CRA FORBEARANCE CFA is aware that many within the banking industry have seized upon the President's community development bank initiative to promote CRA forbearance . These are misguided and unproductive suggestions which will only exacerbate the very problems that the President's initiative is designed to solve . As a result , CFA will be compelled to oppose any legislation that links community development bank capitalization to CRA forbearance . The idea that the establishment of a network of community existing development banks will relieve banks of their responsibilities would defeat the basic purposes of the Administration's proposal -- the expansion of credit and banking services in low- and moderate- income communities . As this Committee is well aware , for many years , banks -- particularly the larger institutions - have suggested that they be allowed to make onetime contributions to CRA compliance and then be excused from further concern or participation in the low- and moderate- income areas of their communities . This has been unacceptable in the past and remains so today . Some of the proposals that have been circulated on community development banks propose that commercial banks could help finance or provide capital for the community development banks and let this contribution serve as their complete CRA program . With this contribution , as the suggestion has it , banks would expect to receive a "gold star " and an outstanding rating for their check to the local development bank . Such a proposal would not create more credit or more service -- it would simply shift the responsibility of CRA compliance to a community development bank at a net loss to the President's goal of expanding financial resources . Suggestions have been made that commercial banks be granted CRA forbearance for equity investments in community development banks up to 5% of their core capital , or an amount equal to less 6 183 than 1 % of their assets . Under this proposal , far less would be leveraged than that under today's CRA -- a CRA that many , including CFA, believe is woefully under enforced by regulators and disregarded by the industry . For example , last month Sumitomo Bank of California announced a CRA commitment equal to 10% of its assets . Similarly , last year Nations Bank , one of the country's largest institutions , committed to deliver $10 billion in new community development loans on top of its existing CRA portfolio . Again , an amount approaching 10 % of its assets . Even under the existing enforcement regime , CRA is capable of leveraging ten times the most optimistic projections of these forbearance proposals . There is nothing to be gained by enacting proposals that would result in less leverage than is currently achieved under the CRA. Clearly, this is not what the President has in mind nor should it be a serious consideration of this Committee . In addition , the suggestions of the forbearance advocates fly in the face of existing regulatory policy on the treatment of these types of equity investments . Since 1971 , the Federal Reserve Board has permitted bank holding companies to make equity investments in community development projects . These investments have been valuable components of many local economic development and job creating projects . Yet , the Federal Reserve has carefully advised holding companies that community development " investment activities alone are no substitute for comprehensive , ongoing bank CRA programs " (Community Development Investments , Board of Governors of the Federal Reserve System) . The Director of the Division of Consumer and Community Affairs at the Federal Reserve , Griff Garwood , recently clarified , in testimony before the House Banking Committee , the Board's policy on community development investments : "The Federal Reserve believes that the use of community development corporations and investments has limitations and that these mechanisms should not be oversold .... [B ] ank related CDCs should not be viewed as a panacea for the ills of out urban neighborhoods and rural communities , nor as the main vehicle for bank activity .... [ T ] he community development equity investment option is an important and useful tool , one that we believe can effectively supplement ongoing bank lending programs ....Under current provision of the CRA , CDCS and project investments can provide positive contributions to an institution's CRA performance , but they are not considered to be a substitute for the institution's CRA program. " Finally , CFA is concerned that these proposals would not only 7 184 not produce more credit , but would institutionalize the very economic divisions within local communities that generated the President's call for community development banks in the first place . These proposals would literally leave the nation with a separate but unequal banking system. The commercial banks , with their Federal insurance , would send their check across town to the community development bank and that would be all -- the banks , with their vast resources , would be invisible in those areas of their community . Such a separate system would have a corrosive impact on development in the inner- city much as the separate educational facilities did on the population of the South prior to Brown v . Board of Education in 1954 . It is absolutely essential that commercial banks remain part of the entire community . The Community Reinvestment Act requires that banks help meet the credit needs of the entire community including low- and moderate - income neighborhoods . Allowing banks to meet this requirement by simply sending a check across town would defeat the letter and certainly , the spirit of CRA . Banks , whether we like it or not , carry considerable clout in every community in this nation -0 tremendous economic and political clout . It is important that the banks , their officers and directors have a stake in all areas of the community . As intended by the CRA , we want to see relationships develop between banks and all the sectors of the community . Only with this ongoing dynamic will banks at long last develop a " feel " for the community and an understanding of the differing cultures and economic circumstances that exist on both sides of the tracks within their communities . Community development banks cannot fill this gap of understanding alone and real economic development is impossible without it . As has been true in increasing cases , banks have discovered that citizens of inner -city neighborhoods can be good credit risks and that they can be the source of profitable lines of business . Great Western Savings and Loan of California has testified before this very Committee that it makes money in the inner-city and it finds the lowest default rate among mortgages in the low- and moderate-income ranges . It is a learning process that would not have been possible had Great Western simply been allowed to send a check across town to a community development bank . CONCLUSION A final note . It is critical that a community development banking initiative not result in the stigmatization of consumers and communities who will become targeted populations of the effort . This is why opening up the mainstream commercial banking 8 185 system through the provision of basic banking services and ensuring adequate enforcement of the CRA are critical elements of a successful comprehensive approach. No one can build assets without a means to cash a paycheck , pay monthly bills and safely save what is left over -- however meager . Ensuring access to basic banking services is the prerequisite of financial empowerment and lasting community economic development . 186 190 VISA podifond esas 61judies so sestien 16 bho Illi t /zoan Crepes : -3 regolaveb Dison The Oweesta Program Your Investment in Reservation-Based Economic Development First Nations Development Institute 69 Kelley Road Falmouth, VA 22405 703/371-5615 187 The Oweesta Program American merican Indians living on reservations face manybarriers to economic development. Since capital has always originated from large infusions of federal funding, small-scale financing is virtually non-existent. Most Indian land on reservations is held in trust and tribal members have no access to mortgages or home equity loans. Reservations lack the vehicles and familiar forms offinancing available tomost other American populations. New, improved housing was just one ofthe results ofthe First Nations' work with the SaginawChippewa Tribe throughthe Oweesta Program. The Oweesta Program is one suchvehicle. Named forthe Mohawkword for money,the Oweesta Program was developed in 1987 byFirst Nations Development Institute. The Oweesta Program is the onlynational program that assists tribes in reservation-based lending and capital management. The Program does so for a variety of purposes and always in culturally-appropriate ways. The Oweesta Program helps tribes manage trust settlements and other financial assets. More importantly, it helps tribal members form equitable and long-lasting relationships with border town banks and other financial institutions. 3 70-832 - 93 - 7 188 The Blackfeet NationalBank in Browning, Montana benefits from Oweesta Fund investments. The bankis Indian-owned and managed. BLACKFEET MAYONAL BARK The Oweesta Fund: Your Investment in Reservation PHOTO: TIM RICE An investment inthe OweestaFund puts capital directly on reservations throughout the United States. The OweestaFundwas used to start the Lakota Fund on the Pine Ridge Indian Reservation in South Dakota, the first micro-enterprise loan fund inthis country. The Fund has also made investments in the Cherokee Community Loan Fund inTahlequah, Oklahoma, the Tlingit and Haida Tina'a Fund in Southeastern Alaska, the Navajo Community Fund in Shiprock, New Mexico, the SissetonWahpeton Credit Union in South Dakota, and the Blackfeet National Bank in Browning, Montana. Economic Development The Fund is also being expanded to help provide affordable housing for 12 tribes inNorthern California, to help the Fort Belknap Community Coop secure muchneeded land for their sheep farming and to aid the UmatillaTribe in restoring the land base on their reservation in Pendleton, Oregon. The Oweesta Fund is funded by a pool ofinterested and dedicated investors who lend moneyat low orno interest to First Nations for re-lending. In return, First Nations works with tribes to insure goals and objectives are met. Investors include private individuals and religious groups, along with the Ford Foundation, MacArthur Foundation and other philanthropic organizations. 189 The Oweesta Program, and its lending component, the Oweesta Fund are administered by FirstNations Development Institute, a not-for-profit reservation-based economic developmentorganization. First Nations is a Native American organization dedicated to advancing culturally-appropriate development. First Nations' President and Founder, Rebecca Adamson, a Cherokee from NorthCarolina, is an internationally known expert in economic development Ms. Adamson also sits onthe Board ofDirectors of the Calvert Social Investment Fund, the Ms. Foundation and the National Center for Indian Enterprise Development Though headquartered in Falmouth, Virginia, First Nations does all ofits work on reservations throughout the United States. The Oweesta Program is one of6 ongoing program components. Other program areas indude Field Sites, Policy, Education, Research and Marketing. First Nations has a staff of twentyand an annual budget of $3 million. The Lakota Fund on thePine Ridge reservation, was the first Oweesta site and thefirstmicro-enterprise loan fund in the United States. Here an artist seils her artwork. Many artists borrowfrom the Lakota Fund. FirstNations is classified bythe Internal Revenue Service under Section 501 (c)(3) of the IRS Code as a charitable, tax-exempt organization. Contributions to First Nations are deductible to the extent permitted bylaw. Financialsupport for our work comes from private foundations, corporations, religious organizations and our ownearned revenue. First Nations is not supported by anygovernmentnor does it receive any Federal funding. First Nations is proud of its record as one of the mostsuccessful and oldest Indian economic development organizations in the country. Answers tothe most commonly asked questions are included on the following pages. For more information, contact Debra Levy or SherrySalway Black, First Nations Development Institute, 69Kelley Road, Falmouth, VA 22405, 703/371-5615. 5 190 Questions and Answers WhoAdministers theFund? about your The Fund is administered by First Nations Development Institute as the capital pool for its Oweesta Program. investment How large is the OweestaFund? in Indian Country It is currently capitalized at $1.3 million. The Fund should reach $3 million by 1995. What is the minimum investment? First Nations prefers to work with amounts of $25,000 or more, although some exceptions have been made in the past for lesser amounts. The minimum term is three years. What is the interest rate paid? Most investors provide interest-free loans. Interest can be paid up to the Federal Reserve Bank's Discount rate in effect at the time the loan is made. Please check with our offices for further explanation. 6 191 How is the money invested? Funds are put to work in Indian Country immediately. Your investment will be used to start loan funds, finance housing and land acquisition, and leverage local financial power. Funds awaiting disbursement are invested in a combination ofthe following vehicles: (1) Indian financial institutions, credit unions and banks that work well with tribes, sociallyresponsible banks and other instruments; (2) Obligations issued or guaranteed by the United States of America or by an agency of it; (3) Certificates of deposit, times deposits or investments fully insured by the Federal Deposit Insurance Corporation of the Federal Savings and Loan Insurance Corporation in any banking or savings institution; (4) Certificates of deposit or accounts with banks or corporations endowed with trust powers having capital and surplus in excess of $50,000; and (5) Commercial paper at the time of investment rated at least A-1 by Standard & Poors Corporation or Prime-1 by Moody's Investors Service, Inc. When is interest vaid? Interest is paid yearly or twice yearly. Can the loan be assigned to another vartu? PHOTO: VERN KORB The Oweesta Program includes access to capital through the Oweesta Fund andaccess to information and education through the program. Top: The Oweesta Fund is expanding to help finance projects such as housingfor u 12 Tribe consortium in Northern California. Below: The Oweesta Conference isjust one ofthe many educational programs offered. Our standard investment agreement allows for the assignation ofthe loan to another party after one year of investment. Exceptions can be made. 7 192 How secure is my investment? As with most types of socially-responsible investments, your investment is an unsecured loan to the Oweesta Fund and should be thought of as a highrisk investment. In five years of existence, the Fund has never defaulted or failed to repay a loan. In fact, most investors " rollover" their investments when theycome due. Your rights as a creditor are neither superior nor subordinate to any other investor in the Fund. What types ofsafeguards exist? The Oweesta Fund is used to capitalize culturally-appropriate economic development. The Oweesta Program helps tribalmembers hone their business skills anddistribute theirproducts to awider audience. First Nations invests only in programs that meet our standards. Loan funds, for example, must have large loan loss reserves; individual loans made by the fund cannot exceed $10,000, etc. As was mentioned, the Oweesta Fund has never defaulted or failed to repay an investment on time. What types ofreporting mechanisms are there? The Oweesta Fund is audited annually and copies are available to any investor. The Fund is administered through the Trust Department of the Kellogg Bank, Green Bay, Wisconsin. Groups that have received loans provide quarterly financial and semiannual program reports to First Nations. They are required to re-pay interest quarterly. What types of reports will I receive? All investors receive copies of First Nations' BUSINESS ALERT every other month and copies of any annual or other reports produced .* 8 193 RESPONSE OF MILTON O. DAVIS TO WRITTEN QUESTIONS FROM SENATOR RIEGLE Question 1 -Community Lending: (A) Are these institutions addressing fully the credit needs of distressed communities? (B) What credit needs are not being met and why? Answer 1 : A broad range of credit needs in distressed communities continues to be significantly underfinanced. These needs include , among others , small- and middle- sized business start-up and expansion loans, micro business transactions , conventionally financed mortgages for the purchase and/or rehabilitation of rental housing, and credit for community organizations , home improvement and singlefamily mortgages. The reasons for this lack of credit fall broadly into three categories. The first set of reasons includes many deals which should be bankable by conventional standards but are not financed due to racial and cultural obstacles. Other deals are avoided because most banks seek what appear to he more attractive markets . Conventional banks, with the proper incentives, could meet these needs . Second, many deals in distressed communities are only bankable by specialized institutions with sufficiently targeted market knowledge and expertise to evaluate, structure and finance them appropriately. Distressed communities need access to credit from lenders that are willing to find ways to make this lending a source of good business. These credit needs in distressed communities often do not fit the standards set by traditional lenders: the loans are too small, the borrowers are less financially sophisticated; lenders are unfamiliar with the neighborhood; and lenders are unwilling to partner with other sources of financing or enhancements to enable comprehensive redevelopment efforts . Specialized finance institutions with a focus on and commitment to community development such as community development banks or loan funds are designed to meet these needs. The third category is less about credit than about comprehensive community development-the purpose of development banks . Access to credit by itself is insufficient to revitalize a distressed community. Disinvestment is a market phenomenon and , consequently, will only be reversed by fundamentally reinvigorating local markets . Permanent, self- sustaining community renewal results from creating an environment where private investors inside and outside the community are confident their investments will be rewarded as healthy community dynamics are restored. If the focus is community development, perhaps the largest category are nascent credit needs: deals which are generated by supporting entrepreneurial energy through extended, mutually reinforcing, financial and non-financial community development interventions. Comprehensive community development financial institutions can be designed to meet these needs. Community development bank holding companies, which include a comprehensive set of nonbank affiliates , are particularly suitable for this purpose. 194 Question 2-CRA Enforcement: (A) Can the credit and revitalization needs of distressed neighborhoods be satisfied completely through better enforcement of CRA? If not, why? (B) How can we strengthen enforcement of CRA to better meet the credit needs of distressed communities? Answer 2: As suggested by the prior answer, credit needs in distressed communities cannot he completely met through CRA enforcement. Disinvested communities frequently require far more intensive intervention than can be provided through conventional banking institutions. Indeed, even community development banks function only in communities which retain or attract some working class base. However, a large portion of the credit needs (the first category identified in the answer to question # 1) could be met by conventional banks subject to rigorous CRA enforcement. Incentives for conventional banks to meet those needs are critical, and would complement and reinforce specialized efforts to meet the other categories of unmet need . There are 11,000 commercial banks in the country. Each of these institutions employs seasoned loan underwriting talent, has proven credit mechanisms and controls, and knows how to operate within a prudent and regulated context. Regulatory enforcement of CRA, an Act in force now since 1977 , has not yet succeeded in motivating the vast majority of these institutions to apply this talent to adequately addressing the credit needs within disinvested communities. Alternative financial institutions do not operate on a national scale or magnitude that would enable them to fill the void left when conventional banks do not adequately invest in their communities. Clearly, a successful reinvestment strategy should engage commercial banks, through CRA implementation and other mechanisms , in initiatives that provide credit to distressed communities. In order to ensure that there is access to conventional credit in disinvested communities, clearer CRA guidelines and better enforcement are needed, particularly to reverse racial disparities within some lending markets. CRA examiners need to analyze lending patterns within individual institutions and pay particular attention to the lending policies and practices of those institutions that have fewer loans in minority areas and/or higher denial rates for minorities. The evidence of disparities in some lending markets, particularly in home mortgage lending markets, is mounting. It is imperative that Congress and banking regulators work to ensure that every borrower has equal access to credit, regardless of race or gender. CRA regulators need to better educate safety and soundness regulators to the variety of tools used to make loans in low- and moderate-income communities so that financial institutions do not feel there is a conflict between the requirements of CRA examiners and the requirements of safety and soundness regulators in terms of the evaluation of loan portfolios . Small business lending, in par- 195 ticular, has recently been negatively affected by these kinds of discrepancies. The regulatory agencies, or the Congress , should consider two procedural changes to CRA to improve its effectiveness . First, regulators could partially apply the practice of the educational and medical professions, which rely on peer review, by adding a banker and a qualified community-based representative as members of every CRA examination_team. In addition , an annual working session should be convened to make specific recommendations on improving CRA enforcement. The working session should include approximately fifteen representatives of regulatory agencies, bankers (and/or banking associations), and community-based organizations . CRA should be more performance and output driven: less concerned about appearance and more about the amount of credit that gets extended directly or indirectly-to low- and moderate- income communities. This requires , among other things, more clarity from banking regulators on what counts for CRA "credit." Examiners and banks need to be reminded that compliance with the law requires assuring the actual making of loans (by the institution and, in some circumstances, through intermediaries) in low- and moderate-income areas, i.e. , getting dollars into communities that have been significantly underserved by financial institutions . Thus , while documentation of compliance is important, lending is more important and, of course, the factor that ultimately counts in achieving CRA's public policy objective. Because some credit needs can most efficiently be met through specialized institutions, regulators need clearly and specifically to recognize that financial partnerships with intermediaries can help extend the ability of some banks , especially those institutions without retail lending operations , to meet the credit needs of low- and moderate-income people. These partnerships could include community development banks, community development loan funds , community development credit unions and micro credit programs as well as nonprofit community development corporations . Finally, positive financial incentives should be created to further encourage community reinvestment lending by conventional banks . New, much sought after, banking and non -banking privileges should be awarded to institutions that meet specific, high thresholds of CRA performance . Question 3- Distinction : (A) Can you explain to the Committee what factors make CDBs distinct from other institutions? (B) Why do you feel that the creation of a CDB was necessary to address the needs ofyour community? Answer 3 (A and B): Community development banks are generally distinguished from conventional banks by their development specialization and targeted comprehensiveness of banking and non -banking activities . They tend to be distinguished from other community finance institutions by scale (as regulated depositories) and , again , often by comprehensiveness of activities . 196 Shorebank defines a community development bank as a bank holding company with a specialized structure which is organized to transform the market dynamics of a geographical target area. This structure, including a bank and community development subsidiaries, has a number of attributes which make it particularly wellsuited to promote the revitalization of distressed communities . 1. A community development bank is designed, to be, a comprehensive community development institution which, in addition to a bank, includes other development subsidiaries and affiliates that complement the investment activities of the bank . These subsidiaries and affiliates enable a development bank to aggressively identify and better evaluate opportunities and initiate development activities; and to address multiple dimensions of community renewal, ranging from developing retail shopping centers to upgrading labor force skills, Through its non-bank development affiliates , the institution can invest equity capital in businesses owned by others , rehabilitate and construct residential and commercial real estate, operate social development and business technical assistance programs, attract other private and public investors, and generally link residents, financial resources and Government programs into a coherent renewal effort. 2. A community development bank is further distinguished from conventional banks by its specialized commitment to the revitalization of a targeted area for the benefit of current residents. Through its leadership , ownership and governance structure, the development bank makes its mission the long-term development of a community. It measures its success in terms of the development impacts it has on that community. It becomes a permanent institution whose success is joined with the improvement of the community. In order to accomplish its mission , the development bank's leadership and staff must bring together highly localized knowledge of the community, technical banking skills , and a broad understanding of the strategies and process of economic development. 3. A development bank combined the structure and expertise of a for-profit financial institution with the commitment to place one normally sees in community-based non -profit organizations . By developing specialized expertise in carefully targeted areas, and achieving synergies through comprehensive coordinated interventions , a development bank is able to manage the tensions between the goals of profitability and community development impact, making development profitable. In contrast to many community-based organizations, profitability is an essential feature of a development bank. Profits enable the bank to be self-sustaining and to grow and assure that continuing business discipline will be brought to the task. However, while profitability is essential, the shareholders and management of a development bank recognize that its goal is not to maximize profits, but to help effect lasting community renewal . 4. A development bank also combines the qualities of a community-based, market-driven, private institution with unusual scale , expertise and ability to leverage resources. A development bank is a uniquely capable delivery agent for external public and private resources. Many private and Government programs are not fully available in the communities for which they are intended because of lack of sophisticated , market-based delivery systems. A develop- 197 ment bank uses foundation investments and grants, Federal loan guarantees , secondary markets , low- income housing tax credits, JTPA and numerous other programs to accomplish common objectives. A development bank can be considered a "handyman " of sorts, intimately familiar with particular local problems, equipped with a "toolbox" of varied Government and private "tools" to address them, and possessing the expertise to select and productively use the appropriate tool. 5. Finally, a development bank can be flexible and innovative. Location dictates strategy and design : the organizational structure and the strategies or tools it employs can be adapted to a wide range of circumstances. Thus, whether a bank or other kind of large scale, regulated depository institution is most appropriate, and what affiliated activities are needed, will vary from community to community. For example, Shorebank's structure reflects its goal of revitalizing older urban neighborhoods . Southern Development Bancorporation uses a different array of affiliates than Shorebank, because it has been designed to specialize in business and rural development rather than urban community reinvestment. Conventional banks and community development banks do not compete; they are natural partners . Community development banks operate in a market niche which is generally not "bankable" except by such specialized, comprehensive institutions. In effect, they "grow" the market for conventional banking much more than they take a "slice" of the existing "pie." Question 3: (C) How do CDBs fit within the spectrum of all community lending institutions? Answer 3 (C): CDBS tend to be the most comprehensive and well-capitalized model. Through their ability to use the lending and deposit gathering properties of insured depository institutions and the proactive community development properties of various types of subsidiaries, development banks offer unusual potential to affect a broad economic development strategy and achieve scale of impact . Unlike traditional banks, development banks are extraordinarily proactive in the design and delivery of coordinated bank and non -bank products to meet the credit and community development needs of distressed communities. However, it should be recognized that "disinvested" communities are not all alike. The degrees and categories of credit need vary. In response to different needs, a variety of types of community development financial institutions has emerged to fill the credit gaps in low- and moderate-income communities. These institutions provide a critical, alternative and accessible source of financing for meeting the capital and credit needs of distressed communities in ways that increase employment, income or housing opportunities over the long term and with broad-based impact. Each of these types of community development financial institutions plays a separate and distinct role in meeting community capital and credit needs. Some are defined with a broad economic development focus, others are narrowly focused on the delivery of a 198 small number of development credit products. Generalized descriptions (which cannot do justice to the individual institutions) reflecting some of their distinctions follow. 1. Community development credit unions are a particularly effective vehicle for connecting very low-income people to mainstream money management techniques. The deposit and financial transaction services of CDCUS make mainstream banking services accessible and affordable to people that otherwise might have to use expensive and unregulated check cashers and "under the mattress" savings accounts. The consumer lending done by CDCUs is often the only source of loans for expenses like education, home improvements, or used cars that enable people to get and keep jobs . Lending to individuals can have a significant impact on a community scale as opportunities for individual advancement make local community economic development a reality. 2. Community development loan funds specialize in making loans for "unbankable" deals. Through their lending, they often make projects bankable, train borrowers to use credit, and fill a credit gap that cannot be filled by conventional banks . CDLFs serve as a delivery mechanism for social investment capital that is willingly invested at risk for a financial return that is generally below market rates, in order to further the goals of community development. Through their willingness and ability to make loans to community projects that are unable to attract conventional bank loans, CDLF's fill a development credit gap that often stands in the way of community-based development. CDLFs foster new borrowers , make new loans that enable borrowers to establish relationships with traditional financial institutions, and provide technical assistance to help borrowers establish the kind of experience and track record necessary to secure future loans from banks. 3. Microcredit programs provide a very specialized type of development credit to individual entrepreneurs who seek to be self- supporting through income from their businesses . Although not a community-wide strategy for economic development, microcredit programs do provide access to capital to very small businesses owned by low-income persons, often women or minorities, who are otherwise unable to borrow. Because microcredit programs are designed to provide tailored, extensive technical assistance and are not limited by the regulatory constraints of depository institutions , they have the potential to make a deeper impact on truly disadvantaged populations. Question 3- Follow Up : One concern raised about the creation of a network of CDBs or other community-based lenders, is that it will create a two-tiered banking system-one that serves the needs of poor communities and the other that serves everyone else. Is this a legitimate concern? Why or why not? Answer 3-Follow Up: This concern is not legitimate if, as has been proposed , CDBs are not established as a wholly distinct "system" with a special charter. An essential feature to CDBs ' success is precisely that they are fully regulated commercial banks operating by the same stand- 199 ards-and with the same legitimacy, credibility and business discipline-as any bank. They are distinct from conventional banks because they are specialized in community development (as, indeed, many other banks specialize in particular markets) , but recognition that this specialization serves public purposes, and so is particularly deserving of support, need and should not constitute them as a different and certainly not a lower tier- system. [Question 4 was missing on our copies] Question 5-Impediments: (A) Why are there so few CDBs and what are the impediments to the formation of new institutions? Answer 5 (A) : Shorebank was created in 1973 by a management team and investors interested in testing the theory that a bank holding company, as a self- sustaining, large scale, permanent institution , could engage in multi -faceted community development, simultaneously helping revitalize communities while operating profitably. For nearly fifteen years, its owners and managers concentrated on refining, implementing and learning the lessons from application of this model in the South Shore community. The last five years have witnessed significant expansion and replication , and at least a dozen communities are currently in varying stages of planning development banks. The perspective gained from almost 20 years of experience inventing the techniques and methods needed to succeed leads us to believe that this model can be broadly replicated in other communities. However, the challenges remain formidable. Experienced personnel with the requisite skills and commitment, capital, and funds for organizing costs are all equally great impediments. Community development banking is a difficult and specialized business that is not for everyone. It requires specialized skills, flexibility and a long term commitment to the dual goals of profitability and community development. Formal bank training programs are not sufficient preparation for management of a community development bank. Establishment of and support for training programs, and perhaps ultimately of a trade association type network of CDBs , deserves consideration. Compared to most community development institutions , development banks are complex and large scale, requiring commensurate amounts of organizational resources and capital. At the same time , community development banks have required patient and dedicated investors who are willing to take greater risks associated with start-up and a new institutional model; who have been willing to forgo dividends and liquidity in favor of reinvestment of profits in development activities; and who support a development agenda. Shareholders willing to fund start-up of and invest in community development banks on this basis are a relatively narrow group , consisting largely of foundations and socially responsible religious institutions, corporations and individuals. Start-up and risk factors generally should decline as experience grows, but considerable obstacles remain. With new Federal programming and appropriate 200 incentives , it may become possible easier for CDBs to attract funding and capital from a broader investor base. Question 5: (B) Are their other community lending models that should be explored as part of a Federal community development banking initiative? Answer 5 (B): Each disinvested community has unique capital, credit and community development needs, as well as strengths and resources . To have an effective impact on these needs , each community development initiative must be tailored to these unique community characteristics . As stated above, the community development bank model has unusual capacity for managing a comprehensive, community development approach. However, other models may be more appropriate for particular communities with differing, or fewer, needs . For example, a disinvested community with a strong community development corporation and good access to an aggressive community-oriented bank and non-bank financing, may be better served by a community development credit union that provides low-income people with access to retail deposit and loan services . While Federal community development initiatives should recognize and support the whole range of community development institutions, it is critical that a "least common denominator" approach not result in folding all of the institutions into one program , which necessarily could not then be appropriately tailored for the particular structures, purposes and needs of the diverse institutions. A community development banking initiative should, for the reasons detailed in my testimony, concentrate on comprehensive depository institutions. Complementary initiatives should be designed for the other institutions, and specific programmatic incentives and support should be created, which could be accessed by any of these institutions. Question 6-Limits of CDBs: (A) Are CDBs a panacea for these ills? Answer 6 (A): While community development banks can be a very effective model with high development impact, they are far from a panacea for urban and rural problems . CDBs are, in part, delivery mechanisms and mediating institutions, succeeding because they attract and foster productive application of human and financial resources from within and without the targeted community. They complement, and cannot supplant, the broad array of Government and private activity which is necessary to restore distressed communities. Furthermore, as discussed below, they can play even this limited function only in certain types of community environments. 201 Question 6: (B) What are the limits of CDBs? (C) What factors or conditions must be present in a community for a CDB to be successful? Answer 6 (B & C): Considering the successes of the few currently operating CDBs , the limits of their capacity are as yet unknown . However, the model is premised on facilitating entrepreneurial energy and potential development opportunities to restart healthy market forces while supporting, among other things, profitable operation of a bank. Some communities have been so devastated by years of neglect, disinvestment and destructive forces that the environment no longer exists for a community development bank to operate or even begin the renewal process. There are other neighborhoods whose markets may simply be too small to support a community development bank. Numerous factors affect how and whether a CDB can be designed appropriately for a particular community. These include the volume and quality of the housing stock; business presence and development opportunities; the presence of a sufficient working class and entrepreneurial population; community and public amenities making it possible to attract residents and investors ; access to capable public and private sector partners; and others. Question 6: (D) What other initiatives should we be examining as part of a Federal community lending strategy? Answer 6 (D): As mentioned elsewhere, incentives and accountability under the Community Reinvestment Act provide necessary, enormous and complementary opportunities to contribute to revitalization of distressed communities. Distinct programs to support start-up of alternative community lending and development institutions should also be created . Finally, a broad range of specific programmatic support for development products ( such as the SBA loan guarantee program) should be enhanced and coordinated , including support which could be utilized by the nonbank affiliates of CDBs . Question 7-Safety and Soundness: Do institutions dedicated to community lending pose safety and soundness problems or create significant risks to the bank insurance funds? How do existing community development banks compare to their peers in terms of loan losses, delinquencies, defaults, returns on assets or earnings, or other indicators of the health of the institutions? What role should the Federal financial regulatory agencies play with respect to regulating institutions that might receive Federal assistance? Answer 7: Shorebank's and Southern's experience suggest that CDBs do not pose special safety and soundness risks . The same safety and soundness regulations currently applied to all banks adequately ad- 202 dress the risks, and should continue to be applied to CDBs . Careful selection and monitoring processes by the investing (non- regulatory) "Entity," as described in my testimony, will also mitigate any risks . Finally, to the extent other support, including capital and training, is provided by the program to strengthen CDBs , it will further decrease their risk of failure. The well -documented problems in the thrift and banking industries did not stem from reinvestment in distressed communities . In fact, the institutions that failed or got into serious trouble were generally not active lenders in low- and moderate- income communities. The charts of Shorebank and South Shore Bank performance submitted with the written testimony demonstrate that their performance compares favorably to their peers , including: -South Shore Bank has been profitable every year since 1975. -1992 was the tenth consecutive year in which the Bank achieved double-digit return on equity. -The Bank's low 1992 net loan losses of just cover one third of one percent (.38 percent) on a $ 161.2 million loan portfolio continue a trend of outstanding performance at a level that has equaled or surpassed the performance of peer group banks during five out of the last seven years. Additional Questions Concerning CRA: To what extent should insured depository institutions receive credit toward fulfillment of their CRA requirements for contributions to or investments in community development financial institutions? Should contributions to or investment in community development financial institutions be sufficient to fulfill an insured depository institution's CRA obligations? Would it be appropriate to exempt institutions from CRA examinations and requirements if they contribute a sum equal to approximately .05 percent of their assets of 5 percent of their capital to a community development financial institutions? Answer to Additional Questions Concerning CRA: Since CRA should be clarified and enforced to emphasize performance objectives-outputs of financing to low- and moderate- income markets-examining the extent of CRA credit should not be focused on whether the financing is extended directly, or indirectly through intermediary community finance institutions which often can more effectively extend it in particular markets. Rather, the extent of CRA credit for such investments should reflect the extent to which the investments result in provision of financing to underserved markets. Considering the limited opportunities for and attractiveness of most indirect investments ; the enormous assets of the conventional banking system ; and the extent to which many credit needs can be better met by the conventional banking system , and would be with appropriate CRA enforcement and incentives , the proportion of total CRA activity which would ultimately be met through indirect investments would remain miniscule . It is extraordinarily unlikely that indirect investment could entirely fulfill appropriate CRA requirements. The extent to which it could do so will depend on the nature of particular institutions and indirect investment opportunities. For example, banks that do not 203 have retail lending operations because they have defined themselves as wholesale banks, investment banks or specialty banks like trust companies would more efficiently fill more of their CRA lending requirements through capital investments in CDBs , if such investments were available. The threshold should be high enough to ensure that the investment is on a par with those banks that have retail lending operations. With respect to banks that have a retail lending operation, investment in a CDB would primarily supplement community lending activities. CRA should be restructured to create, in addition to minimum required thresholds , incentives for much higher levels of community financing. Such incentives might be structured in tiers , such that financing at some multiple of the minimum would create a "safe harbor," and financing at various established higher multiples would entitle the institution to access additional special privileges , such as interstate banking, insurance sales , and securities underwriting. Among other reasons, because the amount of CRA credit for indirect investments will depend on the nature of the institution, its markets and the investee institution , a blanket “buy-out" would not be appropriate, particularly not at levels as low as the percentages suggested in the question. RESPONSE OF LYNDON COMSTOCK TO WRITTEN QUESTIONS FROM SENATOR RIEGLE Question 1-Community Lending: Are these institutions addressing fully the credit needs of distressed communities? [referring to existing "commercial banks, savings and loan institutions, non-profit organizations, and public agencies"] What credit needs are not being met and why? Answer 1: Capital starvation is a principal cause for the economic devastation faced by so many low- and moderate-income communities in the U.S. There is not nearly enough capital investment taking place to support an appropriate level of business development and job creation, housing development, and consumer credit in lower income urban and rural areas. As to the reasons for this situation , we have to begin with examining the performance of the institutions that have the capital base and mission to supply investment for small businesses, housing development, and consumer credit. The most important pool of savings in this country, and the most important source of investment for small businesses, housing development, and consumer credit, is the nearly four trillion dollars in the commercial banking system. What proportion of this pool of savings is invested in ways which benefit the low- and moderateincome population of the United States? I refer now to the combination of all of the loans for housing in low- and moderate- income communities, all of the loans for small businesses located in those communities, and all of the consumer credit provided to low- and moderate-income individuals by commercial banks . My estimate is 1 percent. 204 I've come to that conclusion by looking at Community Reinvestment Act data for New York City, and would be happy to share with you the basis for my estimate. If there have been any studies of this question which could give us a further refinement of this number, I would like to learn about them. As to the reasons for the low proportion of total bank assets invested in low- and moderate-income communities , I suggest that it is only partially related to loan risk. I have yet to see any evidence that this type of lending is unacceptably risky when handled appropriately. I also find it highly interesting that South Shore Bank has been more profitable over the past ten or fifteen years , on a return on assets or return on equity basis, than literally thousands of banks in the U.S. The South Shore story is quite well known in the banking industry by now, yet there is a remarkable paucity of imitators . One is forced to conclude that other banks either don't believe they're capable of replicating the South Shore success, or simply don't wish to focus on community development even if it is a profitable activity. Whatever the reasons may be, I have yet to hear anyone dispute that there is an extremely low level of capital investment taking place in low- and moderate-income communities. Question 2-CRA Enforcement: Can the credit and revitalization needs of distressed neighborhoods be satisfied completely through better enforcement of CRA [Community Reinvestment Act]? If not, why? How can we strengthen enforcement of CRA to better meet the credit needs ofdistressed communities? Answer 2: We at Community Capital Bank support full enforcement of the Community Reinvestment Act. I believe that all of my colleagues in the community development financial institution (ČDFI ) sector share that view. Whatever community benefits are generated by the CRA need to continue and be enhanced. A coalition of CDFI practitioners has put forward a position paper on "Principles of Community Development Lending," which was entered into the Committee hearing record on February 3. All of the members of that coalition have agreed that community reinvestment ought not to be viewed as an either/or situation between conventional banks and CDFIs . Our low- and moderate-income communities need all of the help they can get. The existing CDFIs are dedicated to community development, and have proven to be good at it. Community development lending, like any other form of lending, requires skill and dedication to make it work. Purpose , focus, and skill are the attributes that make CDFIs effective contributors . The problem is that the entire CDFI sector is too small to be able to address the scale of needs of low-income communities . That's why CDFI practitioners have asked for help in our efforts to expand the capacity of the CDFI industry as fast as can be accomplished without sacrificing quality. Nonetheless , even a greatly expanded CDFI sector will be insufficient relative to the total capital needs of low- and moderate-income communities . CDFI practition- 205 ers know that and most actively seek to use their institutions to help leverage greater community reinvestment by conventional banks. There is an opposite problem with conventional banks . There are enormous resources in the banking sector, but it has not been deployed in low- and moderate-income communities . In the seventeen years since CRA was first passed at a Federal level, I believe it has had only a minor effect on community lending patterns. As far as I'm aware, the quantitative amount of total community reinvestment lending has not significantly increased over that period of time. If that performance analysis is correct, the Community Reinvestment Act must be judged a failure so far. Nonetheless , we shouldn't drop it, because whatever help it does provide is desperately needed. To strengthen enforcement of CRA, I highly recommend that the new CRA proposal of the New York State Banking Department be examined. The most important element of this proposal is quantitative measurement of CRA compliance. Quantitative standards for CRA, which could be analogous to the capital adequacy standards of safety and soundness regulation, are long overdue, in my opinion. The New York proposal has not yet been implemented, and the details, including the all-important CRA rating ratios, have not yet been set. The principles of the proposal reflect, however, what would probably be the most significant, and positive, change in CRA since the law was first passed. Capital ratios have been proposed as a basis for both restrictive measures on banks, and for providing greater business latitude to those with excellent capital ratios. A similar approach, combining both "carrot" and "stick," could be taken with community reinvestment ratios. Perhaps greatly improved CRA compliance could lead to a doubling or tripling of community reinvestment lending by conventional banks. This would be a significant change, and well worth pursuing. To think that changes in CRA could cause a greater effect than this seems highly implausible to me, so long as there is a continuing lack of fundamental interest in community reinvestment. There is only so much that can be accomplished with regulatory enforcement and incentives. The problem is that even a tripling of conventional bank community reinvestment would still be grossly inadequate relative to community needs. Again, the central point is that our communities need all of the help that they can get. Question 3-Distinction: Can you explain to the Committee what factors make CDBs [community development banks] distinct from other institutions? Why do you feel the creation of a CDB was necessary to address the needs of your community? How do CDBs fit within the spectrum of all community lending institutions? Follow up: One concern raised about the creation of a network of CDBS or other community- based lenders is that it will create a twotiered banking system -one that serves the needs of poor commu- 206 nities and the other that serves everyone else . Is this a legitimate concern? Why or why not? Answer 3: As to community development banks specifically, they operate under the same regulatory framework as other banks . Nor have I heard any request from practitioners that a separate regulatory structure be created . There are major differences between community development banks and other banks , however. I would summarize these differences as: focus, which can help lead to a skill at this work ; relationships with complementary community economic development services such as technical assistance and equity investment; supportive shareholders and depositors ; and commitment. To elaborate, one of the most important differences is focus . At Community Capital Bank, we have the entire resources of the organization aimed at providing community development loans in lowand moderate- income areas of New York City. Our board of directors, our senior management, and our loan officers all concentrate on community development lending. This creates an environment where we not only have the motivation to succeed at community development lending, since our entire bank depends on it, but we have used the concentration of effort to give ourselves the best possibilities of success. Bank loans are only one part of the spectrum of community development finance needs. The existing community development banks have explicitly recognized this by use of the bank as the anchor for related community development affiliates . In the case of Community Capital Bank, while we have not yet formed a bank holding company, we do have a nonprofit venture development organization, LEAP, operating from the Bank's office. I am the Chairman of LEAP as well as Chairman of the Bank. Shorebank , Southern Development, and Center for Community Self-Help have all been able to been more fully articulate this strategy as they have been in operation for a longer period of time. The shareholders at Community Capital were recruited to the Bank specifically on the basis of the Bank's community development mission, as Shorebank and Southern Development had done. Shareholders and depositors who specifically support the community development mission will object to too few loans in low- and moderate-income communities , not too many. Community development is a long-term process that requires sustained commitment. Institutions that have that commitment are essential. Community Capital Bank was created for the sole reason that adequate bank support for community development has not been present in New York City. Community development banks are only one of a range of community development financial institutions. I also include community development credit unions , community development loan funds, microenterprise funds , and venture development organizations as CDFIs. There are other, related, types of community development organizations that CDFIs interact with, or which could be 207 included in a community development bank holding company. An affordable housing development company is an example. Not only are the needs for community development finance broader than just bank loans, but a particular community's resources may be better suited to some CDFI vehicles than others. For example, a community development bank tends to have the best capital access of CDFIs , largely because of access to insured deposits , but it also requires a large amount of capital to start one. As to a two-tiered banking system, we should realize that would be an improvement over what we have now. Right now we effectively have no banking system at all in most poor neighborhoods. A "two-tier" system could imply that there will be a separate regulatory status for CDFIs . I don't recommend that course. However, I do think that institutions who specifically adopt a program of community economic development as their principal purpose should be assisted as to their startup and expansion, and that it is in the public's interest to do so. The problem with the "two tier" approach is that it implies that conventional banks will not or need not operate in low- and moderate-income areas. That is not acceptable. We should encourage and require conventional_financial institutions to participate in community development. To focus only on CDFIs and give up on that effort would be a serious mistake, and would ignore the efforts that CDFIs themselves make to involve conventional banks. Question 5-Impediments: Why are there so few CDBs and what are the impediments to the formation of new institutions ? Are there other community lending models that should be explored as part of a Federal community development banking initiative? Answer 5: The most important obstacle to the creation of more community development banks has been the great difficulty in obtaining sufficient equity capital. The social investment capital market, which has been the only plausible source for obtaining this equity , is in a formative state and includes no underwriting capability. A further limitation is the relatively small number of experienced bankers, especially those at a senior management level, with experience and an interest in community development. Yet a further problem is the shortage of technical assistance available to groups who would like to start a community development bank. The coalition of community development financial institutions that I referred to earlier includes a variety of types of organizations. I urge that any Federal support program be made available to the full range of CDFIs. Eligibility ought to be defined by an organization's degree of commitment to community development, the relative importance and likelihood of success for its programs in supporting community economic development, and the need for Federal support in achieving that success . Question 6-Limits of CDBs: Are CDBs [community development banks] a panacea for these ills [in urban and rural distressed communities]? What are the lim- 208 its of CDBs? What factors or conditions must be present in a community for a CDB to be successful? What other initiatives should we be examining a part of a Federal community lending strategy? Answer 6: No one has ever suggested that community development banks , or community development financial institutions generally, are a panacea for poverty. Banks are extremely useful tools for marshalling capital and investing it as senior debt. Reasonable access to that form of credit is essential, but not sufficient. Other factors that may be necessary to address community development range from the financial (other forms of debt, various types of technical assistance, and equity capital) , to the managerial (programs to help create a sufficient pool of potential entrepreneurs and business managers), to basic issues of physical security, transportation access, health care, child care, education , and cultural stability. As I noted above , there is also the issue of the limited number and scale of community development financial institutions relative to the scale of need . CDFIs are accomplishing important work, and could do more of that work. It's in the public's interest to help that happen, but that should not be confused with a solution to poverty. Community development banks , like other banks, require the income from a portfolio of quality loans to support the overhead of the institution . The amount of loans needed will vary according to the size of the institution, but even a very small bank will typically need $ 10 million or more of performing loans to achieve breakeven. Further, a bank ought to maintain at least some minimal diversification in that loan portfolio . Smaller scale organizations , such as a loan fund or credit union , can succeed with a smaller loan catchment area and deal flow. It's important that any Federal support that may be forthcoming for CDFIs be flexibly structured. New forms of CDFIs have continued to spring up in the past several years , such as CDFIs that specialize in raising equity for community development. These types of organizations, which have the same degree of community development commitment and focus as a community development bank , should be eligible to apply for a Federal CDFI capacity expansion program . Question 7-Safety and Soundness: Do institutions dedicated to community lending pose safety and soundness problems or create significant risks to the bank insurance funds? How do existing community development banks compare to their peers in terms of loan losses, delinquencies, defaults, return on assets or earnings, or other indicators of the health of the institutions? What role should the Federal financial regulatory agencies play with respect to the regulating institutions that might receive Federal assistance? Answer 7: The four institutions that are usually described as community development banks (South Shore, Elk Horn/Southern Development, Community Capital , and Self- Help Credit Union) have strong financial records according to their published financial information 209 and also from anecdotal reports. No doubt the Committee could confirm this information with the relevant regulators . As to Community Capital Bank specifically, at two years old, we are too young for me to make a statement as to our financial success. We do feel that we are on the right track so far. We have no delinquent, nonperforming, or classified loans to date. Our operations area has run smoothly and quite efficiently. Our assets to employee ratio, for example, is ahead of median for all banks , let alone startup banks . Our deposit base, which now exceeds $ 16 million, has been highly stable and continues to expand. We have not yet reached breakeven, a situation which is normal for a two year old bank. We started out with the expenses of a full bank, but with no loan income to cover those expenses. The growth in our loan portfolio has reduced our monthly operating loss, such that we anticipate profitable operations within a reasonable time frame. In the meantime, we continue to be extremely well capitalized. Accordingly, I don't believe the existing community development banks pose any safety and soundness problems . Further, I don't believe that small business and affordable housing lending in lowand moderate-income communities has posed safety and soundness problems for the banking industry generally. In general, I believe these types of loans have been made according to appropriate banking practices, reviewing the debt capacity, collateral, and character of the borrower. That can not be said, however, for many of the abusive lending practices which have caused immense losses in the banking and thrift industries. No special intervention by banking regulators will be needed because of capacity building measures by the Federal Government for the CDFI industry. Those CDFIs that are supervised by banking regulators should continue in the same vein. Any Federal agency distributing support to CDFIs will presumably use an annual compliance and audit procedure to determine whether the support was used as agreed. That has no bearing on safety and soundness regulation. Additional Questions Concerning CRA: To what extent should insured depository institutions receive credit toward fulfillment of their CRA requirements for contributions to or investments in community development financial institutions? Should contribution to or investment in community development financial institutions be sufficient to fulfill an insured depository institution's CRA obligations? Would it be appropriate to exempt institutions from CRA examinations and requirements if they contribute a sum equal to approximately .5 percent of their assets or 5 percent of their capital to a community development financial institution ? Answer to Additional Questions Concerning CRA: I believe that depository institutions already generally receive CRA credit for contributions or investments in community development financial institutions. On the basis that CDFIs are using those funds to promote community economic development, this is an appropriate regulatory practice. As to the appropriate amount of credit for this activity, it ought to depend on the relative cost 210 and/or risk to the investor bank. A market rate, FDIC insured deposit does not have the same cost or risk to the investor or benefit to the investee as an equity investment, let alone a grant. If the new CRA proposal put forward by the New York State Banking Department were universally adopted, then a quantitative measure of CRA compliance would be established, which I refer to as the "reinvestment ratio. " This would be the bank's amount of community reinvestment loans, adjusted for related community reinvestment activities, divided by the total insured deposits. In the State Banking Department proposal, a " safe harbor" from CRA would only be provided to those banks that had received an “outstanding" rating for three years running. I recently submitted testimony to the New York State Banking Department suggesting extra credit formulas for various CRA activities, including support for community development financial institutions . I further testified that the reinvestment ratio standards ought to be consistent with the needs of the community. For example, I suggested that an "outstanding" CRA rating should require a reinvestment ratio of no less than 10 percent at the very least, and perhaps more. Accordingly, I believe that .5 percent of assets ought to be a totally insufficient community reinvestment ratio to provide a safe harbor from CRA. Using a quantitative approach to CRA, it would be theoretically possible for a bank to achieve all of its CRA compliance just by investing with CDFIs . In actual practice, however, there wouldn't be nearly enough CDFI investments available for a bank of any size to satisfy CRA through this method, assuming community reinvestment ratios on the order of magnitude I suggest were adopted . I understand very well that banks feel that CRA has saddled them with a social burden that is not imposed on other corporations. Banks , however, have chosen their regulated status to obtain easy access to capital through the bank charter and Federal deposit insurance. Because insured deposits , are our country's most important pool of savings , it's critically important that the manner in which those savings are invested benefit our entire population. One-half of one percent of our Nation's major pool of investment funds going toward low- and moderate -income communities seems impossibly low. Thank you for inviting my participation in your deliberations on these important issues . RESPONSE OF STEVEN W. LOPEZ TO WRITTEN QUESTIONS FROM SENATOR RIEGLE Question 1 - Community Lending: Q.1.a. Are these institutions addressing fully the credit needs of distressed communities? A.1.a. No. The majority banks have found ways of loopholing CRA regulations through mere public relations and self serving minority organizations or leaders . Q.1.b. What credit needs are not being met and why? A.1.b. Minority business persons have a difficult time obtaining business loans from the established banks. The reason they don't 211 make loans to minority business people or residence of the inner cities, is because the inner city is perceived as a high risk area and the majority banks don't like making small loans. It takes as much time to package a small loan, as it would a large loan to a well known borrower in an acceptable area. Question 2-CRA Enforcement: Q.2. Can the credit revitalization needs of distressed neighborhoods be satisfied completely through better enforcement of CRA? If not, why? A.2. No, because of the following reasons? ( 1) The lenders from the major banks do not understand how to lend to minorities. (2) If clear directives or commitments to lend to qualified minorities does not come from the Chairman or Presidents of the major banks, the minority communities will continue to be kept outside the economic beltway-no lending will be done. (3) The major banks prefer to make larger loans to well known companies or to well connected referrals. Q.2. How can we strengthen enforcement of CRA to better meet the credit needs ofdistressed communities? A.2. (a) Before the regulators such as the OCC perform audits on a particular bank they should contact the various credit_agencies for recent loan applicants based on zip codes. They can then send out confirmation letters to the applicants to verity loan decision, so when they audit the bank in particular or branches, they would know which log books to ask for. All loan applications should be entered in a log book. In most instances though, minorities get verbal turndowns, without their application being logged, or a credit report drawn . (b) The CPA as it stands today based on the above circumstances is difficult to quantify. Some banks get satisfactory ratings, just by merely underwriting NAACP, Urban League dinners and sponsoring little league teams. Maybe it'd help if quantifiable standards can be delineated and legislated . For example, if Chase Manhattan were to invest 10 percent of its' capital into a minority financial institutions , it could be then exempted from CPA. (c) As much as possible, regulators who understand inner cities should audit urban banks or branches for CPA purposes. Question 3-Distinction: Q.3. Can you explain to the Committee what factors make CDBs distinct from other institutions? A.3. The following factors distinguishes the CDB from regular banks: (1) Apart from the bank owned by the Holding Company, it can become an equity partner in a viable venture bringing needed managerial expertise to a project in most cases . (2) The mission of the CDB is to make a distressed area bankable. It is a niche bank. Q.3. Why do you feel that the creation of a CDB was necessary to address the needs ofyour community? 212 A.3. (a) Due to blatant redlining. (b) The time minorities spend complaining about the mainstream banks they could be practicing capitalism and creating jobs in Grand Rapids, where inner city banks obtained $508 million in deposits from inner city residents, in 1989 they loaned barely 1 percent of it in the neighborhood for mortgages. No business loans were made. Q.3. How do CDBs fit within the spectrum of all community lending institutions? A.3. The mission of the CDB is to groom small businesses into bigger businesses. So there should be no apprehension as to the subsequent participation of major banks-Natural banking market progression should be allowed to take place. The CDB will also need the major banks in the following manner: (a) Loan syndication wherever possible . (b) Farming out some backroom operations to the major banks. (c) Correspondent banking-all of the above can derive profitable fees and earnings for the major banks. The perceived two-tier banking system should not be a concern . The main concern should be to bring African Americans into the capitalistic beltway. This would help to grow the economy and expand our taxable base. The greatest crime that can be perpetrated is to believe that the major banks will change the error of their ways . Question 4-NONE. Question 5-Impediments: Q.5. Why are there so few CDBs and what are the impediments to the formation of new institutions? A.5. It takes approximately $600,000 to start a bank from scratch . (a) Established law firms are typically beyond the financial reach of the organizers . (b) The offering is invariably too small for the brokerage houses -so the organizers and the President of the Bank to be, have to market the stock . (c) The organizers have a limited budget that cannot sustain a coordinated marketing attack to support the capitalization process. (d) Educating the community as to the benefits of owning their own banks . (e) Opposition from Main Street-here in Grand Rapids , two major banks and several corporations have quietly campaigned against the rise of Southside Bank, on the grounds that it is unnecessary. In a predominant republican enclave, one would feel that a self-help project with some assistance would be easily understood. Q.5. Are there other community lending models that should be explored as part of a Federal community development banking initiative? A.5. At this time, myself and the Board members are emulating the Southshore Bank model. 213 Question 6-Limits of CDBs: Q.6. Are CDBs a panacea for these ills? A.6. Although CDB may not be a cure all, their benefits could be the following: ( 1) Recycling indigenous capital throughout the neighborhood to qualified borrowers to help create jobs. (2) Gradually changing the image of distressed areas from welfare to one of a generation of entrepreneurs. (3) Witnessing the building of economic blocs in the community by a younger generation- so they can also be imbued with a "can 39 do spirit . Q.6. What are the limits of CDBs? A.6. (a) They cannot afford to get involved in unprofitable ventures . (b) They have got to be selective about the ventures they finance based on the competency of the support staff. Q.6. What factors or conditions must be present in a community for a CDB to be successful? A.6. A structure that can provide capital to help create economic development. Neighborhood groups psychologically seeing or experiencing the need for economic development. Evidence of a viable income and deposit base. Existence of small businesses waiting to be brought out of incubators. Existence of a core of skilled managerial expertise. Potential for growth in various industries. Q.6. What other initiatives should we be examining as part of a Federal community lending strategy? A.6. (a) SBA loans should be underwritten at bank discretion . (b) If the project financed is viable a two year period of interest payment only, should be an option. (c) If the above suggestions were to be accepted, they should be subjected to periodic audited statements, and strict compliance with SBA audit guidelines . Question 7-Safety and Soundness: Q.7. Do institutions dedicated to community lending pose safety and soundness problems or create significant risks to the bank insurance funds? A.7. They can if the following characteristics are not in place: ( 1) A strong President/CEO who has familiarity of the operational infrastructure of banking. (2) A strong comptroller CPA type who has worked in a major bank as a comptroller to help plan and budget for the bank, monitor cost, etc. and product profitability. (3) A strong and experienced senior lender who is familiar with a variety of loans: Construction, commercial finance, floor planning, letters of credit, mortgage warehousing, etc. (4) A strong and experienced branch manager who knows lending and branch operations. 214 (5) With an experienced competent management staff, support staff training would be ongoing. Q.7. How do existing community development banks compare to their peers in terms of loan losses, delinquencies, defaults, returns on assets or earnings, or other indicators of the health of the institutions? A.7. The only model that I am familiar with is the Southshore Bank, and they appear to be profitable based on financial reporting. Loan losses, delinquencies , defaults are within industry norms. Q.7. What role should the Federal financial regulatory agencies play with respect to regulating institutions that might receive Federal assistance? A.7. They should be treated just like the major banks: Audits by FDIC, OCC and State Banking Departments . Additional Questions Concerning CRA: Question A. To what extend should insured depository institutions receive credit toward fulfillment of their CRA requirements for contributions to or investments in community development financial institutions? A. To the extent that the "investment" is quantifiable , so it can be given a rating-poor , satisfactory or excellent. Question B. Should contribution to or investment in community development financial institutions be sufficient to fulfill an insured depository institution's CRA obligations? B. If there are quantifiable CRA regulations in place to measure a satisfactory CRA rating or an excellent CRA rating, then there shouldn't be any problems . Question C. Would it be appropriate to exempt institutions from CRA examinations and requirements if they contribute a sum equal to approximately .05 percent of their assets or 5 percent of their capital to a community development financial institution? A. I prefer to confine myself to investment instead of contributions . I think the most important thing is to get the majority banks to start cooperating with the minority banks by investing in them; to tackle the major tasks of making distressed neighborhoods bankable. Any target number, that will help to capitalize a CDB and make it viable, should be a good start. If 5 percent of capital will do it, then let it be 5 percent. RESPONSE OF EDWARD H. MCNAMARA TO WRITTEN QUESTIONS FROM SEANTOR RIEGLE Question 1-Community Lending: Are commercial banks, savings & loans, non -profit organizations, and other lending institutions addressing fully the credit needs of distressed communities? What credit needs are not being met and why? 215 Answer 1: Although these institutions meet the credit needs of several "layers" in the spectrum of credit needs , the credit needs in distressed communities remain unmet. In housing, for example, these unmet needs include financing for multifamily housing projects, single family mortgages, home improvement loans, and purchase and rehabilitation loans. In enterprise development (or small business), the needs include, among others, small business working capital financing, early stage and term expansion credit, and microenterprise lending. The reasons for this lack of credit are two-fold: First, the primary purposes or missions of these organizations are broad and not focused on a neighborhood's development (with the exception of nonprofits). Second, distressed communities need more than just credit. They need coordinated interventions that will create demand for credit and make lending activity less risky. The effective delivery of credit in these neighborhoods often requires a specialized knowledge and experience to identify and structure transactions that provide access to credit yet minimize risk to the lender. The primary obligations of commercial banks , savings and loans, and credit unions are to their shareholders . The consolidation in the financial industry has put increased pressure on these institutions to meet the expectations of their shareholders, Wall Street, and regulators and seek the most attractive markets possible. These organizations are not the best-suited to meet the developing credit needs in distressed communities for several reasons: -Loans in these communities are less profitable due to their smaller size, the time needed to work with less financially experienced borrowers, and the lender's unfamiliarity with the local market. Finding good business opportunities in distressed communities requires time, patience, and effort, all of which are additional costs to be borne by the lender. -The institutions are less familiar with distressed and minority communities and therefore less able to assess risk. Many loans that would be bankable by conventional standards are not being made for a variety of reasons, a situation which should change gradually over time. Second, finding good lending opportunities in these markets requires local market knowledge to evaluate and structure loans to maintain a reasonable degree of risk. -Regulated institutions build a diverse portfolio of loans rather than concentrating resources in a particular geographical area or community. In contrast, distressed communities need concentrated and heavy investment to create change. An institution that targets a particular area is forced to find, or make, good business opportunities in that community rather than seeking the best possible opportunities around a broad service area. Many of the credit needs in distress communities are met by non-profit organizations. Although several non-profit organizations are very sophisticated lenders, many do not have the lending experience or capital to provide a comprehensive set of resources. They are not regulated depositories and cannot leverage their capital into a significantly larger amount of development credit. As a public agency, Wayne County is very aware of Government's capacities and limitations. Public sector agencies face pressure 216 from various political agendas, a cycle of frequent change, and high competition for public resources. Government does not face the sink- or-swim discipline of the marketplace that forces a business to adapt and succeed or fail . A non -governmental, permanent organization can make the revitalization of a particular community its primary purpose. In addition , it can efficiently combine public and private resources to achieve that long term goal . The second point is perhaps even more important in Wayne County. If a community is fortunate enough to have conventional , non-profit and public sector lenders and no visible credit gap, there may remain a need for a proactive , initiating activity to create new demand. Unlike most lenders, a community development bank combines a regulated bank with non-bank tools designed to create change in a particular community. As the non-bank affiliates undertake "top down" development projects, they encourage local residents to invest in the neighborhood as well . This confidence evolves into new demand for credit which can be met by the bank. Question 2-CRA Enforcement: Can the credit and revitalization needs of distressed neighborhoods be satisfied completely through better enforcement of CRA? How can we strengthen enforcement ofCRA to better meet the credit needs ofdistressed communities? Answer 2: As described above, the revitalization of distressed neighborhoods requires more than just credit . Therefore , increased enforcement of CRA can only go so far in addressing the complex challenges posed in these communities. Although improved enforcement of CRA would meet more of the credit needs in these communities, banks would continue to see it as a burden to be minimized . Banks and S&Ls might be more motivated to ensure access to conventional credit in distressed communities if certain changes were made. (1) CRA guidelines should be clarified and performance evaluations should focus on the amount of dollar invested, both directly and indirectly. At present, CRA compliance is not driven by outputs. Guidelines should be clarified so banks know what activities earn "CRA credit. " For example, lenders might coordinate with a community-based organization with specialized market knowledge as a way to deliver credit effectively . Regulations should be streamlined so banks can focus on funding ways to increase lending and investment opportunities rather than on documenting community needs and bank research efforts. (2) There should be positive rewards for banks with outstanding CRA performance. The motivation to meet community credit needs might be heightened by using incentives rather than only punishment. Banks with an exceptional CRA performance might earn access to desired activities or broadened powers. Incentives should not substitute for enforcement, as many smaller banks may not respond to the incentives . (3) CRA regulators should be better educated about the range of tools used to make loans in low- and moderate- income neighborhoods. The safety and soundness regulators tend to be unaware of 217 the various tools used to manage the risks of lending to these markets and often contradict the recommendations of the CRA regulators. Regulatory agencies should give their staff methods to evaluate the effectiveness of character lending rather than a sole reliance on collateral values and financial ratios . Question 3-Distinction: Q.3.A. What factors make Community Development Banks distinct from other institutions? A.3.A. A community development bank differs from conventional lending institutions in several ways: -Targeting of resources within a particular geographic area with the goal of renewing the market forces and economy in that particular area . -The combination of banking with specialized, non-banking activities designed to meet the particular needs and opportunities of that particular community. A CDB might use a real estate developer, for example, to undertake top-down housing and commercial rehabilitation projects to make a visible impact on the community and to change perceptions and confidence. It might use a non-profit affiliate to train and place residents in jobs , provide non-bank credit and training to very small businesses, or design support services for apartment building tenants or homeowners. -A singular purpose of long-term revitalization of a particular community and a commitment to permanence. A CDB has an identity of interest with the health of the community in which it operates. If the community improves , the business risk of lending and investing will decline; if the community falters or continues to slide, loans become more risky. In effect, a CDB combines the expertise and commitment to profit of a bank with the neighborhood level commitment of a non-profit community organization. Creative use of multiple forms of resources, ranging from philanthropic money to public subsidy to depositors funds. A CDB is an efficient user of a wide range of tools and resources to best serve community needs. -A CDB attempts to create new demand for credit by changing perceptions and confidence within a targeted community. The non-bank affiliates enter the market first with large scale, top down development projects. As the market begins to change, local demand for specialized credit (such as purchase and rehab financing) increases . As the market becomes more stable , credit risk declines. These coordinated interventions essentially "open" the market and allow normal competition and market supply and demand to resume . A community development bank is distinguished from non-regulated community based lenders by its larger capitalization , its ability to leverage that capital by accepting deposits, and the regulatory oversight that ensures prudent and sound lending practices. Profitability is a critical feature of a development bank. To be a permanent institution within the community and to meet the future credit needs of its customers, a community development bank must earn profits to grow its capital base. By combining the community-based commitment and social/financial approach of a non-profit with the resources and technical 218 capabilities of a regulated bank, a CDB is a uniquely capable delivery agent for public, private, and philanthropic resources. A development bank can marshall resources that would not otherwise come into the community, such as philanthropic investment and grants, Federal loan guarantee programs, secondary market mechanisms, low-income housing tax credits, JTPA and numerous other programs. Because it knows the target market intimately, a development bank can choose the most appropriate tools and use them to reinforce each other and generate synergies. Q.3.B. Why do you feel that the creation of a CDB was necessary to address the needs ofyour community? A.3.B. In the older communities of Wayne County, we have inactive real estate markets that present few opportunities to conventional lenders. Although banks compete for attractive mortgage lending within the City of Detroit to meet their CRA obligations and participate in partnerships with non-profits to provide small business credit, the real estate markets remain an obstacle. Although_significant amounts of public resources have been poured into these communities , the markets are failing to work. We believe that a private sector-managed community development bank can be the mechanism to jumpstart the rebirth of our urban neighborhoods. The development bank will include a regulated commercial bank, a for-profit real-estate developer, and a non-profit providing small business support services and housing assistance. Through a careful targeting of resources , it can stabilize certain neighborhoods that are threatened by blight. The opportunities include attractive housing stock, affordable land values, and a strong home ownership base with block clubs and community organizations . A community development bank should be able to halt the spread of blight through the remaining pockets of strength in distressed neighborhoods throughout Wayne County. Although an effective delivery system for philanthropic, private, and public resources , a CDB is not a panacea. It will rely on serving a cross- section of Wayne County's older communities to combine areas of extreme disinvestment and need with the working class/moderate- income neighborhoods necessary to support a bank. As a permanent, private institution with a long term development objective, however, we believe a community development bank can begin the process of rebuilding our neighborhoods one by one. Q.3.C. How do CDBs fit within the spectrum of all community lending institutions? A.3.C. If the spectrum of community lending institutions is described with conventional financial institutions at one end and nonprofit loan funds at the other, CDBs are somewhere in between. CDBs are much more proactive than banks and S&Ls in the design and delivery of coordinated bank and non -bank products and services . CDBs are also better capitalized and have more comprehensive interventions than most non-regulated community lenders. By accepting deposits , a CDB can leverage the amount of capital invested by 8 to 12 times and convert deposits into development credit. 219 There is a wide range of credit needs within disinvested communities. Different market niches are best filled by specialized institutions. A bank holding company can combine many of these specialized lenders within it (such as a bank and a non-profit, for example), however, a bank also requires higher capitalization and higher revenues to cover its operating costs. There are many markets where either the market is too small or the degree of blight and disinvestment is too high for a CDB to operate profitably. These markets are best served by specialized Community Development Finance Institutions, such as community development credit unions, community development loan funds, and microenterprise lenders who target a particular segment of the market and meet those credit needs. Follow-up: Concerns About a Dual Banking System As mentioned above, Wayne County is very aware of Government's limitations. A program creating CDB's as Government banks would be destined for failure. The success of existing development banks demonstrates that the most effective economic development institutions are market driven and accountable to the businesses and customers they serve. Development banks should continue to have exactly the same status and set of requirements as any other bank holding company and regulated financial institution. The standards of performance should remain high to ensure a business- like approach to development and to ensure prudent and sound lending and management practices . As Shorebank Corporation's financial results have demonstrated, it is possible to be a development institution and a profitable bank. Question 4- missing. Question 5- Impediments: Why are there so few CDBs and what are the impediments to the formation of new institutions? Are there other community lending models that should be explored as part of a Federal community development banking initiative? Answer 5: As the oldest CDB, South Shore Bank has spent many years figuring out what works in distressed and underinvested communities . The Self-Help Credit Union and Southern Development BanCorporation have also adapted these methods to rural environments. The strategy was largely discounted until the 1980s when Shorebank began to achieve scale and momentum. As evidence began to mount that the approach was creating change in these neighborhoods, Shorebank received many inquiries from others seeking advice on replication and adaption . We were one of those parties. The biggest impediments facing those who want to establish a development bank include recruiting capable management, raising patient capital that is willing to accept long term returns , and financing organizational and start-up costs. In addition , new development banks will need to finance technical assistance from exist- 70-832 0 - 93 - 8 220 ing CDBs to avoid reinventing the wheel in the process of adapting the model to their local needs and opportunities. Like any business, the most important element in a CDB's success is capable management. Although there are few "ready-made” development bankers available, we believe there are experienced non-bank lenders with the ability to build and manage an organization. Similarly, there may be bankers who would like to shift to a greater development focus. Regardless of the management team we identify, we hope to receive guidance and management training from existing CDBs. Credit needs and market opportunities vary among communities . In those communities where the credit needs are narrower, in particular, there may be a stronger need for a specialized non -lender such as a community development credit union to provide local banking services, or a loan fund to finance housing institutions, each with a specialized role and market niche. Federal support for these organizations is important to filling the credit gaps in disinvested communities. However, Federal legislation should be focused on the particular support needs of each type of institution , rather than try to meet the needs of all community development institutions simultaneously. Such an approach usually results in finding the lowest common denominator, rather than developing effective and efficient legislation . Question 6-Limits of CDBs: Are CDBs a panacea for the ills facing disinvested communities? What are the limits? What factors or conditions must be present in a community for a CDB to be effective? What other initiatives should we be examining as part of a Federal community lending strategy? Answer 6: Community development banks can be a very effective model for urban and rural economic development, but they are not a panacea. CDBS are an effective means of delivering resources within a targeted, distressed community. While a CDB tries to build the capacity of local residents to access and use those resources, some communities require much greater investment of time. A CDB looks for market conditions to support both the bank and the non-bank affiliates, such as a real estate developer. The bank needs a strong working or moderate-income class population that can borrow from the bank. In contrast, the developer needs an area with sufficient blight that it can attract the subsidy required to undertake large, top down rehab projects . A possible list of target area selection might include: -A sufficient level of distress; -A mixed income population with some working class economic strength; -Population and market opportunity sufficient to support a bank; -Close to areas with healthy economic activity; -Salvageable housing stock (if a housing driven strategy); -Defensible boundaries (which allow targeted investment) ; -Presence of other development actors. 221 Other initiatives that would affect the development impact of CDBS include incentives and accountability under the Community Reinvestment Act. In addition , new ways of delivering portfoliobased guarantees to small business lenders would complement the SBA 7(a) lending program and reduce the usage costs for banks (such as the Capital Access Program run by the Michigan Department of Commerce). Question 7-Safety and Soundness: Do institutions dedicated to community lending pose safety and soundness problems or create significant risks to the bank insurance funds? How do existing community development banks compare to conventional lenders in financial performance? What role should the Federal regulatory agencies pay with respect to regulating institutions that might receive Federal assistance? Answer 7: I will address the first and third questions only, as the second is best addressed by the existing CDBs themselves. First, if CDBs are regulated by the same regulatory authorities as are other banks and bank holding companies, the standard of safety and soundness should not differ from that of other institutions. Risk is mitigated through adequate capitalization , training and development of management, and effective internal control systems and procedures. The strong financial performance of Shorebank Corporation, the CDB with which I am most familiar, suggest that CDBs do not pose any inherently higher risks to the banking system. The greatest risk in the establishment of CDBs lies in a too rapid pace of establishing these institutions. It is more prudent to take the time to design effective legislation and to identify the best candidates for any Federal support rather than aim to produce quantity at the expense of quality. In response to the third question , I again emphasize that CDBs should not come under any special rules or either more or less stringent oversight than any other banks. There are many smaller commercial banks and savings and loans across this country that have engaged in community lending for many years and who have operated under the same regulatory guidelines. A CDB is different in how it combines that lending function with other, non-bank activities . These permitted non -bank activities are regulated by the Federal Reserve. Federal assistance must be carefully designed to not alter the incentives and decision-making behavior of management. The standard for safety and soundness and prudent lending must remain high. Greater education of regulators about the strategy and its approach might make routine regulatory scrutinies less painful , but the performance expectation should be no different than for other financial institutions. Additional Questions Concerning CRA: A. To what extent should insured depository institutions receive credit toward fulfillment of their CRA requirements for contribu- 222 tions to or investments in community development financial institutions (CDFIs)? B. Should contribution to or investment in community development financial institutions be sufficient to fulfill an insured deposiČ. Would it be appropriate to exempt institutions from CRA examinations and requirements if they contribute a sum equal to approximately .05 percent of their assets or 5 percent of their capital base to a CDFI? Answers: A. Insured depository institutions should receive some credit for investments or contributions to CDFIs , as these community-based organizations can often serve a niche market much more effectively than can a regulated bank. The extent of credit granted for such investments , however, should not relieve the lending institution of all of its CRA obligations . Banks are the primary vehicle for basic banking services, consumer credit, mortgage lending and other forms of credit. Non-profit and other CDFIs are designed to fill a market gap, but not to permanently replace a function that rightly belongs with the mainstream financial system. B. No. If a depository is providing a wide range of support services to the CDFI and is providing a wide range of financial services (such as those provided by a bank) through it, then perhaps a higher percentage of CRA is warranted. There should be compliance with the spirit of CRA, not only the letter. C. No. As mentioned above, CRA performance should be evaluated on outputs to the community. If a bank capitalizes or grants funds to a CDFI without the capacity to translate those funds into meaningful access to credit in the community, then there has not been a significant increase in credit outputs to the community. Banks have a specialized training and experience in lending and servicing loan portfolios. That responsibility cannot be passed on to CDFIs which lack the systems, infrastructure, and experienced staff to make prudent loans . RESPONSE OF RONALD L. PHILLIPS TO WRITTEN QUESTIONS OF SENATOR RIEGLE Question 1 - CPA Enforcement: Can the credit and revitalization needs of distressed neighborhoods be satisfied through better enforcement of CPA alone, instead of the creation of a network of CDBS or other community - based lenders? Answer 1: In part. The credit and revitalization needs of distressed neighborhoods (and rural communities) must be addressed through continued and vigilant enforcement of CPA. CPA has helped to stimulate bank involvement in credit markets that otherwise may not occur. However , the creation of CDBs or other community-based financial, housing and economic development institutions are a necessary complement to CPA because these institutions identify, package and present projects to mainline banks for financing that otherwise cannot be developed. 223 Therefore, a CDB or bank affiliation with a community-based organization would represent a more proactive application of CPA. How can we strengthen enforcement of CPA to better meet the needs of distressed communities? Answer 2: Analysis of bank lending patterns continue to show discrimination to minority communities. In many instances , the bank lending officer is caught between two conflicting goals: loan safety, and community reinvestment. Loans to small businesses have been particularly affected by this contradiction . These disparities must be addressed by clearer CPA guidelines for both bank personnel and examiners . But banks do not tend to understand or know how to reach underserved markets. A community development bank is a model for reaching underserved communities , and those who still suffer from discriminatory lending patterns . The community development bank concept must be broadened wherein CPA endorses (and rewards) a bank affiliation with a nonprofit community-based organization (or helps establish an organization if none exists) to develop the market for mortgages, commercial real estate, small business , consumer and other credit needs . In Maine, banks and consortiums of banks have affiliated with Coastal Enterprises to extend credit targeted to certain rural populations, communities and industry sectors (e.g. value-added natural resource enterprises, small business manufacturing, microenterprises, child care centers, affordable housing subdivisions, women, AFDC recipients). How are community- based financial institutions distinct from banks and how can we ensure that support for these institutions does not undermine the obligation of other insured depository institutions to address community lending needs? Answer 3: Capital is a necessary but insufficient ingredient in community development. Community-based financial institutions. are distinct from banks because they perform a variety of pre-credit functions essential to developing credit-worthy opportunities . In a nutshell, community-based organizations : are intimate with their communities and market region; are professionally staffed with people skilled in project development, and mobilizing federal, state and private resources; provide technical assistance to prospective individual and small business bank borrowers ; develop the plans for and manage housing, health or dependent care facilities; and mobilize and provide development capital essential to securing bank participation . If CRA encourages partnerships between community organizations and banks, the capacity of how to meet their obligations will be facilitated rather than undermined; and the lending needs of communities will be significantly enhanced . Question 2-Community Development Needs: What are the most significant development gaps inhibiting revitalization of distressed communities? Answer 1: Among the more significant development gaps are the presence of viable, community-based institutions that demonstrate capacity, scale and permanence to develop their market region . 224 Are there products or services that community-based institutions provide that banks do not, but could provide? Answer 2: Yes. But if a bank formed a community development bank, then it would include the products or services that community-based institutions are concerned about, particularly the approach to community revitalization that is holistic and comprehensive, targeted and inclusive of a variety of nonprofit activities normally not associated with existing banks . For example, the bank would have a relationship to: commercial real estate development; soft lending and technical assistance for businesses , including microloans; venture capital; use of special federal, state or private foundation programs for housing, community and business development. Short of forming a community development bank, by affiliating with a community-based organization , or helping to establish one if none exists, a bank could ensure the products or services needed for the community are being developed. Are there products or services that community-based institutions provide that banks cannot? Answer 3: Yes. Community-based institutions have developed a culture of professionals dedicated to working in low-income neighborhoods, rural communities , and with populations normally cut off from the economic mainstream. This network includes community development corporations, which have developed 320,000 units of low-income housing, 17 million square feet of commercial real estate, and made 3,500 small business loans creating at least 90,000 jobs; community development credit unions ; community loan funds ; and microloan groups. It is not clear that existing banks can , or should try, to completely integrate this kind of culture. As a first step, affiliation with the special capacities of the community-based institution may be desirable. Question 3-Two -Tiered System: Is this a legitimate concern? Why or why not? Answer 1 : It is a legitimate concern if community development banks are seen as a solution to the problems of distressed communities irrespective of the existing banking system or CRA. If, however, community development banking is viewed in its broader sense, that is, as a way to enhance CRA through existing bank affiliations with community-based institutions, then you are getting the best of both worlds : the participation of existing banks , and the partnership with community organizations intimate with the market region. In some communities, formation of a new community development bank as a special institution for certain market niches may be necessary and ought to be valued as part of a community revitalization strategy. If we adopt a policy of assisting community lending institutions, how can we ensure that other institutions are not let off the hook ofproviding credit in distressed communities? Answer 2: Again, CRA must be upheld as the primary inducement to meeting the credit needs of communities . Community de- 225 velopment banking, and affiliation with community organizations, are extensions of CRA, not replacements . Question 4-Community-Based Lenders: How are your institutions different from CDBs? How are they similar to CDBs? Answer 1: How do non-CDB groups differ? Our institutions, that is, community development corporations, community loan funds , and microloan organizations , are fulfilling community development needs that go well beyond the capacity of a bank to perform. We are different because we are performing the nonprofit development functions independent of serving as a regulated, depository institution. Credit unions, however, are regulated, and are much more similar to a CDB in that regard. We are also different because in many instances we affiliate with existing banks to gain their participation in our community development initiatives. For example, in CEI's case, we have leveraged $60 million in bank financing for primarily business and housing projects whose credit needs otherwise would not be met. How are we similar? Commonalities include: targeting of resources of low- income communities; mobilizing other private and public funds for our projects (e.g. SBA 7(a) guarantee program, lowincome housing tax credits, job training funds). What is the justification for including these institutions in any new community banking initiative? Answer 2: There are several sound reasons for broadening eligibility for a community banking initiative. First, the most obvious is the commonality of our goals, inclusion of mainline banks in the process, and overall expanded political base for the community revitalization field. Second, by inference, this question suggests an either/or situation. But a program that supports a menu and diversity of approaches would be more strategic, and have a wider audience. Thus, in some cases , Federal funding to form or further develop a CDB or credit union may be appropriate (to include consideration of FDIC-troubled banks) ; in other cases, Federal funding to spur an affiliation between existing banks and community organizations (e.g. community development corporations , community loan funds , microloan funds) may be appropriate. Third, the field of community development is much broader than CDBs . There are virtually only a handful of CDBS in the 25 years that South Shore Bank has been in existence . On the other hand, there are several thousand community development corporations , community development credit unions, community loan funds, and microloan funds. There are also EDA development districts , municipal and county development organizations, SBA 504 certified development companies , and SBA Small Business Investment Companies. Anyone seriously interested in community revitalization would not bypass the tremendous accomplishments , skills and network that exist outside of community development banking experience . Fourth, as a development model there are reasons for limited replication of CDBs . In part, this is due to the complexity of forming a bank and capitalizing it with significant patient deposits from 226 outside individual and institutional depositors (such as churches and foundations), like South Shore has done. Would this money flow in an accelerated federally-assisted program to form CDBs? And fifth, another reason is that the community development field has witnessed a continuum of need such that credit per se is not the only issue in a distressed community . Rather, the capacity to develop business, real estate or housing projects, to provide technical assistance, training and education , and to offer flexible, “gap financing" sources of capital, are key ingredients in the community development process . Only community organizations have this extensive experience. To eliminate them from a community banking initiative would be like shooting oneself in the foot. Question 5-Market Discipline: If nonprofit organizations are included in a Federal community banking initiative, how can we ensure that the projects developed and financed by non-profits will be financially strong and the Federal Government's interests are protected? Answer 1 : It is absolutely incorrect to assume that the CDB strength as an insured, depository institution imposes a market discipline on community development projects, and that projects are therefore financially feasible, or that nonprofits do not have the same pressure to balance bottom line profitability against community impact. This argument is particularly specious when you realize that a CDB needs subsidy to ensure it can extend credit to a project to ensure its feasibility. For example , South Shore uses the SBA 7(a) guarantee program. It also uses soft deposits who do not demand a return (South Shore has never paid a dividend to a stockholder) to generate "development credits" which in turn are used to "subsidize" loans, technical assistance , or other activities. Further, nonprofit management is no different than a bank's management and bottom-line requirements . In fact, banks , not nonprofits, have tended to be the ones making speculative, unsound investments . CDBs do not exist in any particular number to measure their performance, so there is no comparative reference. At CEI, for example, we have highly qualified financial and technical staff, a board consisting of successful business , bank , financing and community representatives, and a portfolio of projects that have been through rigorous screening and due diligence. We have a strong asset base and net worth . It would be hard for any CDB advocate to suggest that we are not disciplined because we are not regulated . We are audited, and must comply with a variety of fiduciary, contractual and related requirements and standards. Community development corporations have a 25-year legacy in community development. There have been failures. But today, many of these organizations can demonstrate track record; capacity; professionalism; diverse and qualified boards of directors ; audit compliance; net worth and financial stability. CDBs alone have a developed a combined value of some $3-5 billion in housing, business and commercial real estate financing. Community develop- 227 ment credit unions, loan funds and microloan funds also demonstrate growing degrees of capacity and skill. The Federal Government can be assured that its interests are protected with nonprofits, non-CDBs because it can a) rely on the tremendous historic experience nonprofits have gained in project development and management of resources from HHS, HUD, DOL , SBA, FmHA, EDA, and other Federal programs; b) establish qualifying criteria where applicants must demonstrate there capacity, track record, and experience; and c) monitor and evaluate program performance. Question 6—Impediments: What are the most significant impediments to the formation of new or expansion of existing community- based lenders? What types of incentives would encourage their formation or expansion? There are several levels of impediments that, given a creative Federal program, could be successfully addressed : a) CAPACITY BUILDING. Community organizations need funds to plan for and develop strategies for community development; to hire qualified staff; to provide for core funding that does not unduly rely on assets (or deposits ) for earnings. b) TECHNICAL ASSISTANCE. Community groups require training and technical assistance in starting up, operating and expanding their organizations . At CEI, we receive 1-2 serious requests per week, perhaps 50-100 per year, from communities and groups who want to learn about CEI as a model, and replicate our approach either as a start-up or expansion. c) GRANTS FOR EQUITY CAPITAL. Given a local plan and organizational capacity, the most serious obstacle to the start-up or expansion of community-based lenders is grants for their equity capital base. This capital is important because it ( 1) contributes to the net worth of the organization ; (2) provides an earnings base for operations ; and (3) serves as leverage to borrow other funds for project financing. While no data currently exists on the financial worth of community organizations , any group engaged in community financing ought to have a 1 : 1 debt equity ratio. Most community financing groups probably have a 10 : 1 ratio. d) TAX INCENTIVES . Community groups could benefit by favorable IRS treatment of private sector tax deductible contributions . Currently, the IRS has reduced the deduction to something like 30 percent or less . This should be increased to a 100 percent deduction . The Low-Income Housing Tax Credit is being extended ; a similar proposal has been offered for a Federal tax credit to stimulate capital investment in small businesses in affiliation with community organizations . Question 7-Implementation: What entity do you believe is best suited for administering a community development banking initiative, and why? A community development banking initiative that included the menu of funding opportunities and support for the variety of community-based organizations described could be administered by any one of a number of existing Federal agencies . A major concern 228 would be how rural communities are treated and what kind of experience the agency has with rural development issues. Existing Federal agencies have strength and limitations. For example, while HUD has some grasp of housing and urban projects, it has very little understanding of the culture of commercial lending and financial institutions, let alone rural communities. The Treasury has virtually no experience with community development. Federal financial regulatory agencies ought not to be considered because they need to preserve their regulatory status versus a program management and oversight status. The Federal Home Loan Banks have experience in community development, but this is mainly focused on housing. A federally-chartered corporation may be the best route because it provides a fresh start and streamlined context for funding of a variety of initiatives. However, a memorandum of understanding with all the other Federal agencies noted, including Department of Commerce and SBA, and FmHA, should be developed in order to ensure complementary resources. Additional Questions Concerning CRA: To what extent should insured depository institutions receive credit toward fulfillment of their CRA requirements for contributions to or investment in community development financial institutions? Answer 1: They should. I am not familiar with the options of incentives. But as a community development practitioner, the design and implementation of a project could be enhanced with expanded incentives. For example, we are designing a targeted business and self-employment loan fund for economic and worker dislocation around defense department base closings. A consortium of banks is participating. We expect contributions to assist in development of the project, and to match a pool of capital for loans. Should contribution to or investment in community development financial institutions be sufficient to fulfill an insured depository institution's CRA obligations? Answer 1: No. But contribution or investment in a communitybased financial organization should be given special treatment if the scale or impact of credit flowing to or in relation to the community organization's projects is significant. Would it be appropriate to exempt institutions from CRA examinations and requirements if they contribute a sum equal to approximately .05 percent of their assets or 5 percent of their capital to a community development financial institution ? Answer 1: No, banks should not be exempt from CRA generally. But it is a very good idea to structure a funding relationship as a percentage of assets or capital . Another approach would be to have a bank contribute 5 percent of its earnings on an annual basis , rather than a "one-shot" contribution. Such contributions could be significant, and banks ought to get some "special credit" from it as they would be going outside of their normal banking channels to more proactively affiliate with and endow a community organization through their financial structure. 229 RESPONSE OF ROBERT JACKSON TO WRITTEN QUESTIONS OF SENATOR RIEGLE Question 1 -CRA Enforcement: Can the credit and revitalization needs of distressed neighborhoods be satisfied through better enforcement of CRA alone, instead of the creation of a network of CRAS or other communitybased lenders? How can we strengthen enforcement of CRA to better meet the needs of distressed communities? How are communitybased financial institutions distinct from banks and how can we ensure that support for these institutions does not undermine the obligation of other insured depository institutions to address community lending needs? Answer 1: Enforcement of CRA and Federal support for community-based lending institutions are not contradictory or mutually exclusive goals; they should be considered two essential parts of a comprehensive effort to make capital available in low-income urban and rural communities. CRA alone will not get the job done. After more than 15 years of CRA, it is dear that thousands of distressed communities remain cut off from capital. It is also clear that "grade inflation" remains a serious problem; many banks continue to be rate "outstanding" under CRA although their actual lending in poor communities is minimal. Also, in many areas, like the rural community where my credit union is located, there are only a few banks , so that even stringent CRA enforcement would not open floodgates of capital the way it might in an urban center. The proliferation of community development credit unions throughout the United States in the last 15 years is, in and of itself, an indication of the limitations of CRA as a means of spurring community reinvestment. While conventional banks were withdrawing from low-income neighborhoods, many communities-including mine decided to take matters into their own hands by starting locally-owned community development financial institutions CRA may be able to push some banks into reluctantly reinvesting, but this activity is no match for a team of enthusiastic local specialists who are in the banking business for the exclusive purpose of rebuilding the economy of a low-income community. Even with CRA, I don't know of a single conventional bank in the Mississippi Delta that would make some of the housing loans to sharecroppers that my credit union makes all the time. The regular banks just wouldn't know how to do it-they wouldn't know the people, they wouldn't be willing or able to properly assess the risk, and they certainly wouldn't be willing to forego theirs usual level ofprofitability. As you know, I am a member of the Board of Directors of the National Federation of Community Development Credit Unions , which supports efforts to strengthen CRA enforcement. In this regard, we wholeheartedly support the work of CRA advocacy groups like ACORN, the Center for Community Change, the National Neighborhood Coalition and the Center for Responsive Law. We have been in dialogue with these organizations , and have reached a com- 230 mon position that support for community development financial institutions must not in any way lessen the obligation of other insured depository institutions to address community lending needs in keeping with CRA and other Federal laws. Obviously, a bank that supports a community development credit union like mine should get some level of recognition under CRA, and indeed that is currently the case. But it would be a mistake to allow a community development banking initiative to allow banks a "buy-out" from CRA. For all the good work that we do, the Nation's 300 to 400 community development credit unions (CDCUs) are only a small drop in the bucket: our combined assets of about $500 million are loss than the assets of a medium-sized conventional bank. The Nation needs a two-pronged approach that supports the very specialized, grass-roots work that we do, while using us as an example to the larger institutions of how far they need to go to make capital available in poor communities . Question 2-Community Development Needs What are the most significant development gaps inhibiting revitalization of distressed communities? Are there products or services that community-based institutions provide that banks do not, but could provide? Are these products or services that community-based institutions provide that banks cannot? Answer 2: While I do not have comprehensive knowledge of all the problems that prevent the revitalization of distressed communities, I do know that a lack of access to capital is a critical development gap that often blocks economic development. To put it simply, we are asking thousands of small businessmen and homeowner to make capitalism work without supplying the capital. Even very poor people tend to save some small amount regularly; this combined pool of funds is the deposit base that a CDCU draws upon to finance local development. But if those funds sit in a conventional bank, chances are that the money will be completely inaccessible to the same low- and moderate-income people who deposited the funds in the first place. So homes will go unrepaired, and small businesses will fail, and people will be unable to purchase homes and begin to build wealth. Credit unions close the capital gap left by banks. Credit, of course, is the basic product offering that banks could provide in distressed communities. But there are a host of transaction services provided by CDCUS that banks probably could provide if they wanted to . Check cashing, for instance, is often needed in poor communities, but many banks either charge high fees or refuse to offer the service because they don't want a lot of poor people coming through the door. Certainly, the basic service of courteous treatment is one where banks have often come up short when it comes to poor people. Mortgage lending is another area where banks have the means, but not the will, to provide services to people of low- and moderateincome. Banks have the capital and the administrative capacity to make mortgages, but they need to relax some of the iron-clad underwriting standards that tend to shut poor people out of the housing market. 231 By the same token, CDCUs offer a range of services that most banks are simply unable to match. My credit union and others like it spend a great deal of time explaining the basics of the financial system to poor people who have traditionally been simply turned away by banks . We also are able to provide unsecured loans based on the character of individuals. This ability comes from constantly being in direct contact with the residents of a community- something banks no longer seem to be able to do. Our intimate knowledge of a particular community and the people who live in it constitutes a kind of "social capital" that can be used as collateral in communities where financial capital is in short supply. Question 3-Two-Tiered System: One concern raised about the creation of a national network of institutions dedicated to community lending is that it will create a two-tiered banking system. Is this a legitimate concern? Why or why not? If we adopt a policy of assisting community lending institutions, how can we ensure that other institutions are not let off ofthe hook ofproviding credit in distressed communities? Answer 3: I do not recommend that the Federal Government create or define an entire new tier of financial institutions. By relying on simple criteria, it is possible to identify which institutions are already acting as community development banks, credit unions or loan funds. If the institution has formally committed itself to make service to poor people its primary focus, then it's probably a community development financial institution. However, we should not be afraid of making distinctions . The fact of the matter is that decades of underinvestment add disinvestment by conventional banks have created a market made up of hundreds if not thousands of large, capital- starved, underserved communities. Hundreds of community development credit unions have arisen to meet this need, along with dozens of community development loan funds, microenterprise funds and reservation-based lenders. These community development institutions specialize in dealing with neighborhoods that other financial institutions have ignored or written off. If this looks like segmentation within the financial services industry, so be it. More than 15 years of history has shown that, even with CRA, our current " one-tiered system" ends up leaving vast numbers of Americans without an adequate level of banking services. As indicated in my response to Question 1 , Federal assistance for community lending institutions should not in any way lessen the existing reinvestment requirements of banks . If a bank wishes to support a Federal community banking initiative, for example, it should get some level of favorable CRA recognition by its examiner. However, it could be stated publicly by bank regulators that all banks are expected to develop their own , in-house capacity to engage in lending that is similar to the kind being done by local community development financial institutions. The presence of a local community development credit union, for instance, should raise the 232 standard of what acceptable lending is ; local banks could then be asked to try to meet that higher standard. Question 4-Community Based Lenders: How are your institutions different from CDBs? How are they similar to CDBs? What is the justification for including these institutions in any new community banking initiative? Answer 4: CDCUs differ from CDBS in a few key respects. OWNERSHIP . Unlike a bank, a credit union is organized as a nonprofit cooperative, meaning that all control of the institutions rests in the hands of the people who are served by it. A bank must answer to two key constituencies-the bank's stock owners and its customers-whose interests occasionally diverge. Stockholders , for instance, are interested in maximizing dividends, while customers might prefer to use bank profits to lower the cost of various services. A credit union, by contrast, is a cooperative that can concentrate exclusively on serving its member/owners. As non-profits, credit unions do not offer financial compensation to their elected boards of directors ; they also rely heavily on community volunteers. CAPITAL STRUCTURE . The capital structure of a CDCU is also different from that of a CDB. While a CDB accumulates net worth, or equity, by selling shares of common stock, a CDCU can only raise capital by setting aside a portion of the profits from its operations . A CDCU can also accept donations of equity to increase its net worth. EDUCATION/EMPOWERMENT MISSION. Unlike a CDB, a CDCU has an explicit mission of teaching community residents how to manage the institution themselves. By serving on a credit union board or committee ordinary citizens learn about the workings of the financial system; that knowledge is then put to work on behalf of community development. RANGE OF CONSUMER SERVICES . Unlike CDBs , which tend to focus exclusively on making credit available, CDCUS have a central mission of providing a place where citizens can be assured of fair prices on everyday cash transactions. In many neighborhoods , CDCUS are the only alternative to countless schemes-legal and illegal-that regularly cheat poor people. These include pawn shops , currency exchanges, check cashing outlets, home repair scams and loan sharks . The similarities between CDCUs and CDBs easily overshadow the differences, Both kinds of institutions are dedicated to revitalizing low-income neighborhoods through the use of savings and credit. CDCUS and CDBS both rely heavily on "character" as a factor in making credit decisions. Both have acquired the business discipline that comes with being Government regulated. Most importantly, CDCUs and CDBS both use a coordinated combination of financial institutions and non-profit assistance corporations in a comprehensive approach to development lending. South Shore Bank, for instance, is part of a bank holding company that includes a non-profit institution which helps turn housing developers and small-scale entrepreneurs into better bank customers. 233 Without this assistance, many of the bank's successful development loans would be impossible. Many CDCUs (including mine) have a similar arrangement. The Quitman County Development Organization acts as a non - profit "holding company" that created and currently supports the management of the CDCU. The non-profit offers training programs and other assistance to potential credit union borrowers. Given the structural and functional similarities between this arrangement and the South Shore holding company model, I believe that CDCUS-especially those affiliated with a non-profit partner organization-should be included in any new community development banking initiative. Question 5-Market Discipline: How can we ensure that the projects developed and financed by non-profits will be financially strong and the Federal Government's interests are protected? Answer 5: Although CDCUs are non-profit organizations, virtually all are insured and/or regulated by the National Credit Union Administration, a Federal agency. In my experience, NCUA has never been lax about protecting the interests of the Federal Government ; in fact, the more likely danger is that "safety and soundness" concerns may be carried so far as to weaken the level of development lending that CDCUs are capable of undertaking. Question 6-Impediments: What are the most significant impediments to the formation of new or expansion of existing community-based lenders? What types of incentives would encourage their formation or expansion? Answer 6: Until recently, the chief impediment to the formation of new CDCUS has been the NCUA's reluctance of NCUA to approve new charters. Since the fall of 1992, however, a new regulatory attitude has emerged; four new CDCUs have been chartered in the last five months in Denver, Los Angeles , Omaha, and New York. Expansion, unfortunately, is a different story. All too often, Government regulators actively discourage CDCUs from making loans for micro-businesses and home purchases or repairs. These basic development activities are central to the CDCU mission , but they require levels of reserve capital that many CDCUS do not have. Without reserves that serve as a cushion against loan losses , many CDCUS end up looking financially fragile in the eyes of regulators . As a result, the regulators restrict CDCU lending activity, which in turn prevents them from growing. Infusions of equity is the single most helpful way to encourage the expansion of CDCUS . With an additional $ 100,000 in reserves, for example, my credit union could underwrite at least $ 1 million worth of new loans for home repair and other purposes, We would also be able to reduce some of the regulators' fears about risk. 234 Question 7-Implementation: What entity is best suited to administer a program of assistance to CDBS or other institutions? Answer 7: Speaking as a board member of the National Federation of Community Development Credit Unions, my first preference would be the creation of a quasi-public National Neighborhood Finance Corporation, set up in a way similar to the Neighborhood Reinvestment Corporation . The National Federation has advanced this idea for years . Answer to Additional Questions on CRA: At present, banks receive credit toward the fulfillment CRA for making grants to, or deposits in, a CDCU. I view this as an appropriate recognition of the reinvestment work that CDCUS do. However, investing in a CDCU or other community financial institution should never be enough to exempt institutions from its CRA obligation or the requirement to submit to CRA examinations . The size of the contribution is irrelevant the point is that banks are obligated to serve their entirely service area equally. To allow banks to purchase exemptions from this important law would send a dangerous signal about how serious the Federal Government is about enforcing fair levels of reinvestment. Our understanding of the law is that it was never intended to allow banks to purchase an exemption ; rather, it is supposed to be a process through which banks constantly reevaluate their core business and try to make it more responsive and relevant to the needs of all people in a given service area. RESPONSE OF MICHAEL SWACK TO WRITTEN QUESTIONS FROM SENATOR RIEGLE Q.1.a. Can the credit and revitalization needs of distressed neighborhoods be satisfied through better enforcement of CRA alone, instead of the creation of a network of CDBs or other communitybased lenders? A.1.a. Revitalization of distressed neighborhoods can be best achieved by both better enforcement of CRA and the creation of a network of CDBs . CRA will promote more lending in lower-income communities , but traditional intermediaries will never replace the specialized roles played by community development financial institutions (CDFI). Traditional intermediaries and CDFI usually are able to develop a complementary relationship . Traditional intermediaries are able to offer certain types of products and services-but they are quite different from CDFIs. Community development financial institutions must be able to offer a wider range of financing tools than traditional banks. These tools need to include the ability to provide equity, as well as a range of debt instruments. The present regulatory environment would make it difficult for commercial banks to address these financing needs . This regulatory environment limits the types of risks that the bank can take, and limits the range of financial tools available to a bank. Development banking is common in many developing countries. These in- 235 stitutions provide financing in a manner that enhances the financial viability of the project or business seeking financing. The goal is a successful business or project, not necessarily a large return on investment. Q.1.b. How can we strengthen enforcement of CPA to better meet the needs ofdistressed communities? A.1.b. This is a very difficult question to answer. If you try to promote greater compliance through the threat of penalties (e.g. fines), you run the risk of encouraging regulators to enforce the provisions in a lax manners. That is, regulators will hesitate to give bad ratings because they don't want to take the step of imposing penalties. However, if you do not offer specific sanctions for poor performance (the current sanctions only "kick-in" if a bank seeks to expand or sell a branch) , banks have no real incentive to comply with the law. One improvement that could be made within the current law would be to put more emphasis on the current regulation and provide better training to examiners responsible for CPA compliance. My experience suggests that most CPA examiners don't know what to look for, or what questions to ask. They simply don't understand the field of community development. Consequently, it is not uncommon to see banks that take compliance very seriously get only satisfactory ratings (or worse) while banks that do nothing, get the top rating. This is frustrating for banks as well as community development practitioners. Examiners need more and better training so they know what to look for and what to ask. Q.1.c. How are community-based financial institutions distinct from banks and how can we ensure that support for these institutions does not undermine the obligation of other insured depository institutions to address community lending needs? A.1.c. Again, community development financial institutions must be able to offer a wider range of financing tools than traditional banks (see answer 1.a.). Development banking is fundamentally different from commercial banking. The purpose of development banking is to promote self-sufficient and profitable business and housing ventures in poor urban and rural communities. Development banks do not attract profit motivated investors. The South Shore Bank is a commercial bank with a development focus. But even their core investors are social investors- investors who have never been paid a dividend, and whose stock is illiquid. CDFIs promote self- sufficiency, entrepreneurship, local ownership and control of economic resources. The "subsidy" to CDFIs (i.e. in the form of Government investment), is paid back many times. The South Shore Bank is but one example of this "repayment." In South Shore's case, the subsidy came from charitable foundations and religious organizations who were willing to sacrifice a return on their investment. One of the primary purposes of a community development financial institution should be to leverage and develop partnerships with the private sector. For example, a community development financial institution such as a community development loan fund should be encouraged to enter agreements with traditional lenders so as to leverage its own investment with money from the broader capital markets. The development of secondary market mechanisms is 236 critical for CDFIs . Current secondary market mechanisms have been unresponsive to CDFI loans even when the pool of loans being offered by the CDFI is of extremely low risk. A Federal initiative for CDFIs should target the development of secondary market mechanisms as a priority of the initiative and/or stimulate existing federally supported secondary markets to be more responsive to CDFIs. CDFIs should be permitted to offer a wide-range of community economic development programs under one roof. They should be permitted to operate micro-loan revolving funds , venture capital funds, housing loan funds , and programs that encourage the acquisition by community based organizations of their community's resources, especially land. They should also be able, through direct investment or loans, to participate in specific infrastructure projects that allow a community to develop. For instance, on many Native American reservations , access to electricity, water and sewers makes economic development difficult. A CDFI should be permitted to become a partner, either through equity investments, or loans , with tribes seeking to develop these facilities. Q.2.a. What are the most significant development gaps inhibiting revitalization of distressed communities? A.2.a. Distressed communities definitely suffer from lack of capital. Many recent studies have documented this gap. Additionally lack of quality education and training for community residents impedes the development process. Capital alone is not the problem, but it is a significant problem. Q.2.b. Are there products or services that community-based institutions provide that banks do not, but could provide? A.2.b. Many CDFIs offer technical assistance to potential borrowers and specialized loan or equity products. Banks could provide some of this , but regulations would prohibit certain types of investments and the provision of technical assistance is expensive for banks to provide. Q.2.c. Are there products or services that community- based institutions provide that banks cannot? A.2.c. See A.2.b. above. Q.3.a. Is this (concern of a two- tiered banking system) a legitimate concern? Why or why not? A.3.a. No, this is not a legitimate concern. Development banking and commercial banking are two fundamentally different types of banking. I have addressed this in detail in A.1.c. above . Q.3.b. If we adopt a policy of assisting community lending institutions, how can we ensure that other institutions are not let offofthe hook ofproviding credit in distressed communities? A.3.b. As mentioned above, better enforcement of CRA ought to be part of this initiative . There will always be credit needs for traditional intermediaries to address -CDFIs will not obviate the need for traditional intermediaries to provide a wide range of credit to communities and individuals . 237 Q.4.a. How are your institutions different from CDBs ? How are they similar to CDBs? A.4.a. Community Development Loan Funds (CDLFs), Community Development Credit Unions (CDCUs) , and microenterprise funds have some differences and many similarities to CDBs . CDLFs and microenterprise funds differ from CDBS in that they are non-insured institutions that typically don't service a consumer base. CDLFs and microenterprise funds typically provide credit directly to business , economic development and housing projects, but they do not provide consumer and depository services. CDLFs and microenterprise funds are similar to CDBS in that they accept loans from a variety of sources (and incur liabilities to those lenders), serve multiple borrowers, assess risk and underwrite loans carefully and systematically, set aside reserves and adopt appropriate portfolio management policies. Q.4.b. What is the justification for including these institutions in any new community banking initiative? A.4.b. Non-bank CDFIs have proven track records, skilled and experienced management and have built extensive relationships among both lender and borrower markets in their communities. These institutions should be supported to expand their activities because they know their markets and because they have proven that they can lend and invest successfully in low- and moderateincome communities. Successful CDFIs are rooted in the communities they serve. They draw significant amounts of capital from their areas and the boards of directors reflect the composition of their communities. This makes it possible for them to gain the requisite understanding of credit needs and borrower capacity to gauge their lending and investment properly. Institutions created without these strengths and operating with a mandate to lend quickly and in a safe and sound manner, will carry a heavy burden of unachievable expectations. In areas not presently served by CDFIs the Federal Government can help to foster the development of new institutions. Q.5. If non-profit organizations are included in a Federal community banking initiative, how can we ensure that the projects developed and financed by non-profits will be financially strong and the Federal Government's interests are protected ? A.5. Non-profit CDFIs do have the same pressure to finance financially feasible projects as for-profit CDBs . As mentioned earlier, non-profit CDFIs incur financial liabilities just as for-profit entities do. Non-profit CDFIs who make bad decisions will go out of business-just as for-profit entities do . Non-profits are thus subject to the discipline of markets. In New Hampshire, it is interesting to note that in the past 18 months, 5 of the 7 largest banks went out of business because they had made too many bad loans . The two surviving banks survived only because they had substantial capital resources from out-of- state owners. However, the non-profit New Hampshire Community Loan Fund is still in business- with a strong balance sheet and a portfolio of performing loans to low-income borrowers. Institutions that make bad loans go out of business regardless of their legal structure for- profit or non-profit. 238 Q.6. What are the most significant impediments to the formation of new or expansion of existing community-based lenders? What types of incentives would encourage their formation or expansion? A.6. Existing community-based lenders need equity investment or grants to permanent capital. Equity is critical to the long-term viability of any financial institution . Equity allows intermediaries to take greater risk, price loans in a more flexible manner, attract additional investment, and generate earnings that contribute to selfsufficiency. Again , the South Shore Bank, which is held up as a model CDB, benefitted enormously from the large equity investment from religious and social investors . Without this investment, there would not be a South Shore Bank. Additionally, lack of access to long-term debt is a problem for many CDFIs . Another impediment to the expansion of existing CDFIs is the lack of skilled loan officers, managers and directors with experience in community development lending and investment. CDFIs also need to provide technical assistance and training to borrowers . This assistance enhances the probability that loans will be repaid. A CDFI initiative should include funds for CDFI staff training as well as funds for technical assistance to borrowers. See answer 7 for additional ideas on incentives to encourage the expansion or formation of CDFIS. Q.7. What entity do you believe is best suited for this task and why? A.7. One of the key issues facing CDFIs is where they are placed in the Federal Government. I believe that one of the major challenges for CDFIs (and in some ways a defining issue for CDFIs ) is to make sure that they are perceived as financial institutions. If CDFIs are perceived as financial institutions, it will be much easier to be gain access to some of the benefits that financial institutions enjoy and that CDFIs need , such as access to secondary markets . After looking at the range of " placement" options suggested for CDFIs, I believe that being placed within the Federal Home Loan Banks gives CDFIs more opportunities than other placements . Placement within the FHLB system would be desirable for a number of reasons : 1. The members of the FHLB system are banks-CDFIs would be seen as financial institutions not community development programs. I propose that CDFIs would become a new classification of member within the system. Membership within the system could give CDFIs access to member advances . Member advances allow banks to borrow from the FHLB at very favorable fixed-rates for long or short-term . Although many technical details (e.g. capital requirements ) would need to be addressed, the benefit of member advances would be a tremendous benefit to CDFIs . Currently, the FHLBS are owned by member banks who purchase stock in the system when they join . However, the FHLB of Boston recently created a precedent by allowing two public agencies to access funds as nonmember borrowers (two state housing finance agencies). These institutions have full access to member advances. This would open the door to CDFIs . If there is enabling legislation for CDFIs , it could require the FHLB to establish a new category of membership and specify access to membership privileges such as advances. 239 2. Allocation of funds and decision-making could be delegated to the 12 FHLB regions. Each region could have an advisory board comprised of local and regional community development lendersand each region could develop lending and investment guidelines suitable to the specific region. The FHLBs already manage an affordable housing program with regional advisory boards-so they have some experience with this type of program. Regional decisionmaking would provide much greater flexibility than centralized (Washington) decision-making. 3. Operating within the FHLB structure would probably involve fewer bureaucratic problems than would operating within HUD. Additionally, the program_could operate relatively inexpensively within the FHLB system. The program would be administratively inexpensive, non-bureaucratic and economically efficient. I estimate that the program could be run with a small Washington staff and as few as 2-3 people per region. 4. Operating within the FHLB structure could provide easier access to secondary market opportunities. FHLB members routinely deal with secondary market institutions such as Fannie Mae and Freddie Mac. Placement within the FHLB system could provide additional leverage for CDFIs as we try to push these institutions to develop products more suitable to its portfolios . I would also suggest that the enabling legislation for CDFIs should require the Government sponsored enterprises (GSE) to develop the products necessary to service CDFIs. The legislation might even specify that the GSEs must develop products for entities such as limited equity cooperatives and community land trusts (i.e. name products in the legislation), in consultation with CDFIs. GOVERNANCE Based on the regional model administered through the FHLB system , the following governance would apply. 1. The President would appoint the director of the program. This person would be based in Washington at the Federal Housing Finance Board. The director of the program would appoint regional directors, in consultation with the regional branches of the FHLB . 2. The regional directors would appoint a board comprised of regional community development lenders. This board would help design the policies and procedures governing the regional program (within the parameters of the enabling legislation). The board must approve the policies and procedures before the program is initiated. The board would be comprised of two representatives from each state in the region. FUNDING Allocation of funds through a regional FHLB system could work as follows: 1. Appropriations should be allocated to each of the twelve regions. Allocations should be based on a formula which considers both population and population of low- and moderate-income people. 2. Each region should be allocated at least 5 percent of the annual appropriation . 240 3. Funding and investment decisions should be made by region with the instruction that attempts must be made to achieve geographic (funding) diversity both within the region and between urban and rural settings. 4. Within each region , funding for operating support may not exceed 20 percent of the regional allocation . Training programs and technical assistance may be funded at a level not to exceed 5 percent of annual allocation per region . 5. Regional programs may attract additional private investment by offering a tax credit to both corporations and individuals who invest in or contribute to approved CDFIs (need to define what this means). This would be administered through each regional program. Investments in for -profit intermediaries would be in the form of a tax credit of 25 percent of the amount invested in preferred stock (see explanation below of how investments in for-profits and non-profits will differ) . Contributions to the capital of non - profit intermediaries would be eligible for a tax credit equal to 50 percent of the contribution . The amount of tax credits offered by each region would be capped at an amount no greater than twice the annual regional allocation . Administration of a tax credit program will be handled by region . (Note: The New Hampshire Community Development Finance Authority currently administers a state- wide program that grants state tax credits to corporations that contribute to the Authority . This has not been a difficult program to administer for either the Authority or the contributor.) TYPE OF FUNDING Primary funding of CDFIs should be in the form of equity capital investments in for-profit intermediaries, and grants of permanent capital for non- profit intermediaries as follows. 1. Investment in for-profit intermediaries should be in the form of 25 year preferred stock investments with a non-cumulative dividend of about 2 percent. Regulators should be instructed that these investments be counted as the equivalent of perpetual preferred stock (Tier 1 ) core capital until the final five years of the term. For the remaining term , the investments should be considered the equivalent of intermediate-term preferred stock (Tier 2 ) supplementary capital. 2. Investment in non-profit institutions (including CDLFs and CDCUS should be in the form of grants to permanent capital [capital grants ]). This money cannot be used for operating funds, although the earnings on these funds could cover operating costs. There would be no obligation to repay these grants. 3. As mentioned earlier, funds should be specifically earmarked for operating support, technical assistance and training. ADDITIONAL QUESTIONS CONCERNING CRA Q. To what extent should insured depository institutions receive credit toward fulfillment of their CRA requirements for contributions to or investments in CDFIs ? Should contribution to or investment in CDFIs be sufficient to fulfill an insured depository institution's CRA obligations? Would it be appropriate to exempt institutions from CRA examinations and requirements if they contribute a 241 sum equal to approximately .05 percent of their assets or 5 percent oftheir capital to a CDFI? A. Contributions or investments by insured depository institutions should be considered as partial fulfillment of CRA obligations , but it should not replace the requirement that these institutions assess community credit needs and meet those needs. As mentioned earlier, CDFIs meet a particular need but they do not meet the full credit needs of low-income communities. It is vitally important that insured depository institutions continue to meet the statutory requirements of CRA. Thus, contribution or investment in CDFIs should not be sufficient to meet CPA obligations and it would not be appropriate to exempt institutions from CPA examinations for contributing a portion of assets or capital. I . I REVERSE REDLINING: PROBLEMS IN HOME EQUITY LENDING WEDNESDAY, FEBRUARY 17, 1993 U.S. SENATE , COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The committee met at 10:05 a.m. , in room SD-G50 of the Dirksen Senate Office Building, Senator Donald W. Riegle, Jr. (chairman of the committee) presiding. OPENING STATEMENT OF CHAIRMAN DONALD W. RIEGLE, JR. The CHAIRMAN. The committee will come to order. Let me welcome all those in attendance this morning. We certainly have a large and very interested and enthusiastic gathering this morning. Let me say, as we proceed this morning, we've got very serious matters to discuss and everyone here shares that feeling. Many have traveled a long distance because of the importance of these issues and how strongly people feel about it. We have an opportunity today to build an important public record and I want to do that. There may be moments today when things are said or people have strong feelings and want to respond to something that someone has said. I want to ask everyone now, at the beginning, to maintain the order of the committee's work today. It is very important that we do that, because we've got a chance today to examine these issues carefully and fully and to get them out in the light of day. So I am going to need everyone's cooperation to get that done. So I ask for that now. I don't want to have to gavel down anyone in the audience at any point. And there should be no need for that because we want to hear what everyone has to say and we want to be able to build this record fully and carefully. Having said that at the outset, I again appreciate the fact that we have so many people here today. I think it underscores the very important requirement that we examine these issues and do so carefully and fully. The committee today is meeting to conduct its second hearing in a series on the problem of people in our country getting access to capital in low- income and distressed communities. Just 2 weeks ago, we considered the issue of community development lending. Next Wednesday we are going to address the serious problem of mortgage discrimination , of which there is a very great problem in this country . (243) 244 We are proceeding systematically through an inquiry to get at these problems and get them out in the open so they can be dealt with and corrected. Today then our subject is the discriminatory practice of targeting certain communities for credit on unfair terms . Typically the community involved is a low- income or minority neighborhood where housing prices often have appreciated . The residents in many cases are unsophisticated with respect to some of the financial transactions and the way they are presented, and in many cases are easily victimized by unscrupulous financial salespeople. This committee has observed how unscrupulous check cashing outlets spring up in communities where banks and thrifts have deserted low-income neighborhoods , and in turn are charging exorbitant fees. Our subject today is the lending side of the check cashing problem, namely the rise of what I would call shady home equity lenders offering promises of home improvements or credit consolidation. These lenders then often peddle high rate, high fee mortgages to cash poor homeowners. The borrower, who may not fully understand or not even receive disclosures from the lender about the terms of the loan in many cases ends up struggling to meet overwhelming mortgage payments . Too often, the borrower then ends up losing the house to foreclosure. Now the answer to this problem is complex and it gets into the issue of how we regulate certain activities in this country. Some we do at the Federal level, some we do at the State level , and that issue comes into play here. But clearly, better enforcement of laws that are already on the books can help in some instances. Much of the lending activity being complained of is presently legal and therefore is not on its face illegal activity. I want to get to that just a little bit later because we do write the laws of this country. And if they're not the way they should be , then they need to be rewritten. Better disclosure to consumers may also be a solution here in some instances . But there may be instances in which the only solution is, as I say, new legislation. So today, I want to hear from our witnesses on these points. I want to establish a public record. I then hope to work closely with the Clinton administration to better identify the roots of the problem and then, in turn , to find better solutions to it. We have two panels this morning. Our first panel will discuss the origins and extent of the problems in home equity lending and how we might address them. We have four witnesses on that panel. The first will be Scott Harshbarger, who is the Attorney General of the Commonwealth of Massachusetts. Mr. Harshbarger has conducted lengthy investigation of this issue in Massachusetts. Filling out the first panel will be Kathleen Keest, who is a consumer credit specialist for the National Consumer Law Center, Terry Drent, housing coordinator for the Ann Arbor Community Development Department in my home State of Michigan , and John Hamill, who is president of Fleet Bank of Massachusetts . Fleet has had the misfortune to find itself closely associated with this issue in the press , but this problem is broader in scope than any one institution . 245 We welcome Mr. Hamill here today for his testimony and to draw upon the experience and the insight that he can provide us. The second panel will focus on the nature of the home equity loan problem. The witnesses will be Annie Diggs of Augusta, GA, and Eva Davis of San Francisco, CA, two home owners who say they've been victimized by second mortgage lenders. We will also hear from John Long, an Augusta, GA, attorney involved in related litigation, and Bruce Marks, who is the executive director of the Union Neighborhood Assistance Corp. Mr. Marks , I might say, has been a driving force in bringing the second mortgage problem to light and it is important that he testify today. We have also received written testimony for this hearing from the Legal Aid Foundation of Los Angeles, the New York City Office of Consumer Affairs, including a study that they have given us that we will make a part of the record. The Legal Aid Foundation's Home Defense Center in Georgia, and the Legal Aid of Bilouxi, Mississippi, and any others that may wish to submit testimony or statements for the record. And we will keep the record open. Let me note for the record that several of this morning's witnesses are involved in litigation related to the subject of our hearing today. It is of course not the function of this committee today to try to settle or in any way try to resolve these lawsuits. That just can't be done in this setting. Our purpose today is to try to determine what the laws should be. I ask all of our witnesses if they would keep that in mind and help us in turn find the answers they need and lay a foundation in fact, so that we know where a new law may well serve us properly. Finally, I want to stress again the relationship of this hearing to the larger and pervasive problem of an inadequate flow of credit to low-income communities on fair terms and without discrimination. This is a major problem in this country and it has to be dealt with directly. As I say, this is one of several hearings in which we are doing it. But I am determined that we will face and solve that problem. Racial discrimination and the denial of credit to people who are creditworthy in this country, because they are being excluded from the system, either on racial grounds or geographic grounds, or because they are in certain neighborhoods, is absolutely un -American and it has got to come to an end. And I am determined to see that it comes to an end. That is why four of our first six hearings in this Congress focused directly on this subject. I am very much committed to working with all the members of this committee and with the Clinton administration that feels very strongly as well on these issues to address these matters directly in a specific legislative package and as a top priority that's got to be dealt with now before more damage is done to our people and to our country. So again, I want to thank all of our witnesses for coming this morning, many from long distances. And we look forward to your testimony. Senator D'Amato. 246 OPENING STATEMENT OF SENATOR ALFONSE M. D’AMATO Senator D'AMATO. Thank you very much, Mr. Chairman. Mr. Chairman, today's hearing obviously focuses in on a situation that is evil, that is pernicious , that is unlawful, and that really is a stain on the financial community, as well as one that we share for having permitted this pernicious practice of discrimination and consumer abuse to take place. When an elderly person is conned into taking a second mortgage and I say "conned"-into taking a second mortgage to pay for some repairs, and within a matter of months cannot make those payments , than any decent credit analysis should demonstrate very clearly that he or she did not have the income to make the payments on this mortgage. It is intolerable to then have that elderly person's home foreclosed on, to put them out of the home that they have spent a lifetime of savings and scrimping only to receive nothing for it. And that's exactly the kind of thing that is taking place in a number of our States, Mr. Chairman. State law in some cases is so permissive, without mentioning the individual States, that it often allows and encourages these kinds of practices. For example, some States have no laws licensing mortgage brokers or setting limits on interest rates on second mortgages . We will hear today of other States, like Georgia, that have laws that actually authorize interest of up to 5 percent a month. That's 60 percent a year. That's loan sharking clear and through and it should be made illegal. [Applause. ] Mr. Chairman, too many Americans are losing their homes as a result of these fraudulent practices. Homeowners in credit starved areas are often pressured into taking out second mortgages, usually on usurious terms and conditions to pay for home repairs, to consolidate debts, or to obtain needed cash . Despite the illusion of big money on easy terms, the reality for these borrowers is often foreclosure and the total loss of their accumulated home equity. Mr. Chairman , so-called reverse redlining is among the most pernicious forms of racial and ethnic discrimination and consumer fraud. The innocent and unsuspecting victims of these outrageous practices have worked hard to realize the American dream of home ownership and their dream of home ownership has been twisted into a living nightmare by the so -called "tin men" and loan sharks. Mr. Chairman, these abusive practices must come to a halt. Unfortunately, current laws-the Real Estate Settlement and Procedure Act, known as RESPA, and Truth-In -Lending-do not provide adequate protection for consumers and borrowers in the second mortgage market. And the con artists exploit these gaps to the financial and emotional detriment of our constituents and our communities. I have prepared legislation, Mr. Chairman, which I was going to introduce today, that will provide an important first step toward filling in the gaps in consumer protection . It is called the " Home Ownership and Equity Protection Act of 1993." Now, I said that I was going to introduce it today. I am going to withhold it and circulate it so that hopefully we can make it a 247 bipartisan act, an act that will give real and true disclosure, and provide consumers with an opportunity after the initial application is made for a person to reflect upon its terms. It will call for real disclosure and if, indeed, another 48 hours or so can bring forth suggestions from this committee and from staff to enhance and make it a better bill, as a first step toward a solution to the problems we will hear about this morning, this Senator would be pleased. In short, the bill would provide a 3-day cooling off period between the time of the loan application and closing. We establish strict penalties for noncompliance with these enhanced disclosure and delivery requirements. And we mandate a comprehensive Federal study of the entire second mortgage market. I think that is important, so that we don't over-regulate. But by the same token, we get a comprehensive review. But this enhanced disclosure is something that I think is a first step that we should begin to move on quickly. Under the bill, consumers will be warned in writing at least twice about the dangers of taking out a second mortgage. The 3day waiting period, as well as the 3-day recision period already required by Truth-In-Lending, will give homeowners more time to consider and understand the responsibilities and risks associated with loans. I believe that our financial institutions have a very real obligation themselves . They simply cannot hide behind the fact that there is some company out there doing this. That there are independent contractors making these deals. That's not good enough. You cannot do that; it's wrong. [Applause.] We have a credit-starved community. You have an obligation to see to it that if you make funds available, that the people really have the ability to pay back. No one wants to see unnecessary foreclosures. It's wrong. I have had it happen to someone in my family who should have known better; he didn't. It's wrong. It is wrong for institutions that have a very special charter with America and the American people and the American Government not to act responsibly. It should not be necessary for us to pass this legislation. It obviously is. So I hope, Mr. Chairman, that we can at least come forward with a basic bill that will provide more disclosure and begin to move us in the right direction . And I hope that the great financial institutions of our country begin to exercise a greater degree of care and concern in this area. Thank you, Mr. Chairman . The CHAIRMAN. Thank you, Senator D'Amato. With you and I both having stated our intentions today to introduce legislation of a comprehensive sort, I think we will be able to do that on a bipartisan basis and offer it in a way that can move it ahead. I think it would be very constructive. And I think today we will get a lot of valuable information as well that will help us in guiding the construction of that package. Senator Campbell, let me start down in the order in which members have arrived for any brief opening comments they want to make. Senator Campbell, we are pleased to call on you next. 248 Senator CAMPBELL. Thank you , Mr. Chairman . I have a complete written statement. With your permission , I would like to introduce it into the record. The CHAIRMAN. Without objection , so ordered . OPENING STATEMENT OF SENATOR BEN NIGHTHORSE CAMPBELL Senator CAMPBELL . Just to tell you, I appreciate your doing this hearing and certainly intend to co- sponsor your legislation to correct some of the problems we have had with some of the predators who have given the lending institutions a bad name and taken advantage of people who are very often the people who have the most difficulty in our communities trying to make a living. Very often, homeowners have nowhere to go for credit because mainstream institutions are reluctant to lend to low-income families; and these are the homeowners who are targeted by second mortgage lenders and charged very high rates of interest. I am not well versed in the banking industry as you know, just coming on this committee recently. But I have always been interested and concerned about the disadvantaged and minority communities , particularly inner cities and Indian reservations, as you might know. So I am interested in learning a little more about this. I have tried to collect all of the written material which I will go over in my office, since I do have a conflict this morning. But clearly we have an obligation , a moral and legal obligation , I think, to make sure that those people who have been predators on the disadvantaged in this country, to make sure that that's stopped . We might not be able to go back in time and fix all of the mistakes that have been made and all of the unfair practices that have been made. Hopefully, courts will do that and find justice for those people who have been taken advantage of. But we can surely move forward and prevent it from happening again. Thank you, Mr. Chairman. The CHAIRMAN. Thank you very much. Senator Bennett. OPENING STATEMENT OF SENATOR ROBERT F. BENNETT Senator BENNETT. Thank you , Mr. Chairman . I apologize in advance that I have a conflict that will not permit me to hear all of the testimony. But I want to make it clear that this is a matter that requires very careful study and something that members of the committee should pay very close attention to. I am delighted, Mr. Chairman, in your comment, in your opening remarks, about the issue of whether this is a Federal jurisdiction or a State one. Because I think much of the problem may have arisen from the fact that States assume that there are Federal laws on the books that take care of this and therefore ignore it. And the Federal Government very often is the least effective agency for enforcing things of this kind. And it does require local administrators and local regulators who are closer to the situation and can say this is going on. So I hope in the testimony that we address not only the question of the outrages , but the basic question of where the most intelligent 249 enforcement should take place and what the Federal Government can do to facilitate activities on the part of State and local regulators . And I am delighted that we have some State regulators here to address that question . I assure them that even though I do have a conflict that will require my leaving, that I will read their testimony very closely and pay close attention to the recommendations . Because this is an area that we need to pay very close attention to and see what we can do to alleviate the problem. The CHAIRMAN. Thank you very much , Senator Bennett. Senator Kerry, you may also want to make a comment about the fact that our first witness this morning will be your attorney general from your State. Senator KERRY . Indeed, I would like to do that, Mr. Chairman . The CHAIRMAN. A position with which you have some familiarity. OPENING STATEMENT OF SENATOR JOHN F. KERRY Senator KERRY. And with the gentleman himself. Mr. Chairman, I think first of all I would like to join colleagues in reflecting my own appreciation for your leadership. And I am glad to hear Senator D'Amato withhold in an effort to try to put a bipartisan effort together. I am confident we can. I think it is very important we do. I also want to underscore how important I think this hearing is and this effort is. It is larger than just the examination of the predatory practices that have caused considerable and appropriate outrage among a number of citizens . But it really goes to the larger issue of a relationship between institutions, important institutions, financial institutions with great power, and people who do not share that power. It is an effort by this committee and others to try to transfer some of that economic power back to people who have been victimized by redlining and a series of other practices amounting to economic abuse of our urban areas. I am particularly pleased that the leadoff witness is our attorney general from Massachusetts. He rightfully carries a well -earned reputation as a law enforcement officer, as a crime fighter, but also as a crime fighter who understands this other relationship I am talking about with respect to the non -street crime that you see every day. It has been important for our State, and I think he is to be saluted for that. The work he did on this is groundbreaking and important. It is really the best of what attorneys general and district attorneys ought to do in protecting citizens. And I salute him for it. I also want to welcome John Hamill here who has the difficult role of trying to articulate within an audience that is obviously suspicious of any corporate person representing an institution that is associated with the downside of some of these practices. In fairness, I think it is very important for people here to understand that John Hamill is an outstanding business leader in our community, somebody we have enormous respect for. I know from my personal dealings with him and efforts to get minority lending increased and in our efforts to try to augment bank 250 purchasing among minority businesses and other things, that his own sensitivity to this issue is real and that he does not condone these kinds of practices. And I think it is important to listen to whatever explanations are offered with that in mind. Let me also say it is very clear that this committee has got to come up with some kind of response to what we understand to be an unconscionable relationship between disadvantaged people and institutions with the power that we have described . Not every person or institution who loaned money to poor people, incidentally, on second mortgages, committed improprieties. We understand that . But on the whole, there really were substantial abuses within the industry which wound up causing people to lose their homes for no legitimate reason. Over the past 2 years, my staff has interviewed a number of people from different parts of Massachusetts who met with these lending practices. And we have heard from over 70 people who received loans from Dime Bank in New York under circumstances that any person of common sense and decent conscience has to say are unacceptable. We had instances where we had what was called a "no doc" lending process. No documentation . No normal documentation for folks who were supposedly a larger credit risk. The whole process of home buying was sped up. The less sophisticated borrower was lured. They were only required to put down 20 percent downpayment, but in many cases there was no documentation of their ability to do that, no income verification , no credit history. These "no doc" loans made it easier for fraud to occur. Real esunchecked.. Incomes were inflated, tate transactions went unchecked downpayments were sometimes financed by the developers themselves as a second mortgage . Appraisals were falsely inflated . That institution, and another one that has subsequently been put out of business by the RTC were the only two who dealt this way in Massachusetts, I want to add. But they used techniques called negative amortization where they had a teaser interest rate with interest accruing from the moment and suddenly it would balloon to such a degree that people simply never had a prayer of being able to pay this . No one can accept that. So, Mr. Chairman , I think it is important to build a record today to understand precisely how this occurred and what the implications are. I salute you for holding this hearing . The CHAIRMAN. Very good, Senator Kerry. Senator Domenici , did you have an opening comment? Senator DOMENICI . Mr. Chairman, I have a few pages of remarks. Would you put those in the record? The CHAIRMAN. Without objection , so ordered. OPENING STATEMENT OF SENATOR PETE V. DOMENICI Senator DOMENICI . Mr. Chairman, I think it is conclusive now that something is amiss with reference to inner cities and minorities, their ability to borrow money either for real improvements or for home building. For a long time , people said it wasn't so, but it is so . Frankly, we are quickly coming to the conclusion that you cannot fix inner cities with Government programs solely. Nothing works that way . 251 That's why you have banks , that's why you have a secondary market which bundles up home mortgages and then permits banks to even lend more for homes. Frankly, what we are doing thus far seems to all be counter productive on the Government end, and I think we need some real answers. Why isn't FHA more active? Before we go around criticizing others, we'd better find out what's wrong with our Federal programs . Something has to be amiss. The CRA, which we take so much pride in and credit for, isn't even working in this area. It's being finagled in ways that it comes out that there's still no real help for the individuals that want to improve where they live. We allowed tax deductions for home equity loans. I say to my friends here on the committee, which said you can borrow money and deduct that interest. That's working counter to the poor people in inner cities because what is happening is they're pooling their non-equity indebtedness and end up with a huge indebtedness on their house. And they are ending up losing their houses in the name of permitting them to deduct the interest payments. Mr. Chairman, I don't have the answers, but I think it's pretty clear that we need many resources applied to the inner cities aside and apart from Federal programs. We need what every other part of America applies to the community, led by mortgages and loans for real home improvements and for housing. That is not happening. The Banking Association of America has to face up to it. For years they said it didn't exist. Now if we've got to believe the Federal Reserve on this one, they looked at it carefully and they told us it does exist. So I just don't think we ought to convene these hearings with the idea that we are looking for excuses . We are looking for answers . Maybe we have to change some things to help this occur. But it is happening, there is no doubt about it. Mr. Chairman, and Ranking Member D'Amato, I laud you for the hearings . But more importantly, I really hope we can get together and find some ways to improve this situation . Without it, it's not going to work. Putting in more community development block grants, I say to the members it's just going to be a little superficial thing. It's not going to fix the resources that ought to be flowing to individual family members who need that kind of help . Thank you very much. The CHAIRMAN. Thank you , Senator Domenici. I want to note that Senator Murray was here and had to leave to attend to something. We will make her statement a part of the record. The CHAIRMAN. Senator Shelby. OPENING STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Thank you, Mr. Chairman . I, too, am disturbed by the notion of the elderly and the less sophisticated among us being preyed upon by the over-zealous financial institutions. I believe, Mr. Chairman that this type of conduct is unconscionable at best. There's a lot of fraud in this type of lend- 70-832 - 93, 9 252 ing in America. Fraud must be stopped. I don't believe there is any place for fraud or predatory lending of this type in America. [Applause . ] The recent settlement in my State of Alabama indicates that this has been and may continue to be a problem in Alabama. I am interested in learning more about the problem of reverse redlining. And I am very interested in what we can do to ensure that unwitting borrowers are not taken advantage of by predatory lenders. Particularly troubling to me, Mr. Chairman, is the idea that a lot of borrowers are unaware that they are using their homes to secure a home equity loan on a second mortgage. These borrowers may get in over their heads and end up in a lot of cases losing their homes. Mr. Chairman, I believe no borrower in America should be unaware of what collateral he or she has used to secure a loan of any type. However, Mr. Chairman , having said this, I think as these hearings go along, we have to be careful about interfering in the marketplace, interfere as little as we have to. We use the term "redlining" to describe a community that has been shut off from credit. The term "reverse redlining" suggests that a community has access to much too much credit, a notion that is not all bad if it were carried out right, if we had conscionable people making those loans. Mr. Chairman , I have an additional statement I would ask to be made part of the record. And I, too, want to commend you as Chairman for bringing about the leadership in having these hearings and I want to commend Senator D'Amato for his foresight and leadership in the same area. The CHAIRMAN . Thank you , Senator Shelby. Senator Boxer. OPENING STATEMENT OF SENATOR BARBARA BOXER Senator BOXER. Thank you very much, Mr. Chairman. I will be brief. I also want to echo the praise that has been heaped upon you and Mr. D'Amato this morning. I also want to say to the people who are here that I think it is absolutely terrific that you came out. What you've heard already should give you great heart and great hope. I have been in this system for a long time and to hear the kind of commitment that you have heard from the majority and the minority today is , I think, a very good sign that something good is going to happen and that you the public-have played a role by bringing these issues forward. Mr. Chairman, many times, as you know, the people who are most hurt in these pernicious schemes are often the people without a voice. That is why it is so important for us to be their voice. Twenty years ago I was a newspaper reporter, Mr. Chairman, and I wrote a story about an elderly woman who had this little dream house and this little dream picket fence and roses in the front, and she succumbed to one of these people who came and said, "gee, I can give you some more money and you can buy some gifts for your grandkids. " But it was never explained to her that in just a few months, maybe a year or two, she would be hit with 253 a balloon payment that would be more money than she ever hoped to get her hands on . So she lost the house. We wrote the story and everyone was stunned and shocked and everyone thought this certainly would never happen again . But it's still happening, 20 years later. But I am sitting in this seat and I feel privileged to be able to do something now rather than just write about how to fix the problem. I am going to work with you, Mr. Chairman . The bottom line is our home is our castle. And we can't let someone pretending to be a knight in shining armor take that castle away. That can no longer continue . So I will work with you and do everything I can to make sure we fix this problem . The CHAIRMAN . Thank you very much, Senator Boxer. [Applause. ] I think what we have here today is a pretty good example of democracy in action . We have a lot of citizens here and I am very encouraged by that. Mr. Harshbarger, you have been previously identified . We are going to start with you. I am going to ask each of our witnesses on this first panel to try to keep your summary comments to about 5 minutes if you will so we've got time for questions. As you know, we have got a second panel coming behind you that will illustrate some of the very problems that you are going to talk about, but on individual terms. I want to make sure that we've got enough time this morning to get through all of that . So if we can try to adhere to that, that would be very helpful. Mr. Harshbarger, we will start with you. STATEMENT OF SCOTT HARSHBARGER, ATTORNEY GENERAL OF THE COMMONWEALTH OF MASSACHUSETTS Mr. HARSHBARGER. Senator, thank you very much. I commend you as Chairman and the members for focusing on this issue and obviously, my colleague, and a leader on this issue, from Massachusetts, Senator Kerry. It is nice to be here. I am Scott Harshbarger, the attorney general of Massachusetts . I thank you for this opportunity to outline the work of my task force, which investigated the home improvement and mortgage scams in Massachusetts . I would ask that my full testimony be entered in the record. The CHAIRMAN . Without objection . Mr. HARSHBARGER. I would also ask that the report of our task force, which contains in detail a number of our recommendations for you as well as for others in Massachusetts, also be entered into the record. The good news. For the past 2 years, we have undertaken a comprehensive program of enforcement, regulatory and legislative action to remedy the harm done to vulnerable consumers in Massachusetts by unscrupulous lenders and home improvement mortgage contractors. The bad news . Our investigations documented and uncovered the worst kind of urban economic violence which blatantly victimized thousands of vulnerable homeowners . 254 These vulnerable homeowners, elderly, people of color, and people in our inner cities, were targeted by certain brokers, lenders, and contractors to take out second mortgages with unconscionable terms and conditions. If the consumer had sufficient equity in his or her home to cover the loan in case of a default, irresponsible lenders motivated, as best we can tell, primarily by greed gave scant attention to whether consumers could repay their loans with their monthly income. As a result, the consumers were burdened with unmanageable debt and, in numerous cases, lost their home through foreclosure. The words of one victim best sum up the impact that these scams have on people. She said to me, "They did to me what a man with a gun in a dark alley couldn't do; they stole my house." Following the complaints that we received and many of the leaders of the community groups involved in this are here and will speak to you this morning-I mobilized the Home Improvement and Mortgage Task Force from the Office of the Attorney General to address, on a variety of fronts, this insidious form of urban economic violence. To date, the Task Force has initiated thirteen enforcement actions. These actions have already produced more than $40 million in legally enforceable benefits to Massachusetts consumers, particularly consumers of low- and moderate-income. The targets and the participants in these actions were banks, home improvement contractors, and a variety of other mortgage company officials. We also promulgated unprecedented and creative regulations to curb future abuses, and new mortgage licensing and home improvement laws have been enacted to legislate positive change. We recommend them for your consideration. But the obvious question is, how and why did this happen. First, many inner-city communities across Massachusetts and elsewhere in this country were entirely abandoned by mainstream lending institutions during the 1970's and 1980's . As a result of the vacuum that was created when the mainstream financial institutions left, the only credit available to inner-city consumers was from the then unregulated and unlicensed second mortgage companies. This economic exploitation was aided by unethical brokers who extracted unconscionable fees from consumers, and who, in some instances, had undisclosed financial and corporate ties to lenders whose primary goal, apparently, was the acquisition of real estate in a then rising market. I believe a second reason why these scams flourished is that for over a decade, there has been a wholesale abandonment of our cities in this country by many States, and by the Federal Government. If these scams had in fact occurred or were occurring in middle class suburbs of this country, as we saw with the savings and loans scandals, the Federal " cavalry" would already have arrived on the heels of the scam artists. But instead, the social fabric of many inner-city urban neighborhoods was allowed to be torn apart and communities destabilized . And these destabilized communities , as you know, and as Senator Kerry in particular knows from experience, are the breeding 255 ground for further forms of economic violence and other types of violence. Our Task Force uncovered and documented allegations of wrongdoing by home improvement contractors, lenders and brokers , against vulnerable consumers. We have given examples in my prepared testimony and our report of what was documented. I stress that only because this is a field where allegations are often made. Our investigation documented misrepresentations of the nature of the transaction to the consumer, illusory inducements, pressure and coercive tactics, failure to disclose key elements of the transactions , forgeries and falsification of documents , and unconscionable or unaffordable loan terms, many of which examples have been described by members of the committee here this morning. Our attack therefore was multipronged. In addition to 13 actions that targeted banks, mortgage companies, home improvement companies, and individual home improvement salesmen and mortgage company executives , we did promulgate new consumer protection regulations to create a " level playing field" for all the lenders , particularly legitimate lenders who were playing by the rules and were protecting the consumers from these abuses. We played a major role in working with the State Legislature to secure the passage of a new law, regulating home improvement contractors, registration , licensing and a guarantee fund to protect consumers. And we initiated, and with the support of over 100 lenders in Massachusetts, a voluntary moratorium which was then followed by a legislatively-passed moratorium that precluded foreclosures during the period of our investigation . Please allow me to mention just a few things in terms of recommendations. We must look at the Community Reinvestment Act, and ensure that its requirements are absolutely enforced and that the Act mandates address issues that have been focused on here today. Let me give just some examples. Given that the unscrupulous preyed upon the vulnerable and filled the vacuums that the mainstream financial institutions left, we must insist that more banks put branches in lower income communities. We must insist that they market credit products designed to meet the needs and resources of low-income consumers, and market them aggressively. The banks must reach out actively to low- and moderate-income consumers , and become, if you will, more "user friendly," as they did in the middle 1980's for the "yuppie community." I apologize to those who may have been in that group. [Applause .] It is also clear that we need far more flexible and liberal lending criteria for mortgages in a number of areas . And, in addition , we must insist that long-term plans of banks include locating in urban communities. We must also ask the banks to look at their financial relationships to other lenders. The fact is, in these situations , consciously or unconsciously, mainstream banks in Massachusetts did finance 256 high rate equity lenders who made loans in areas where those banks were not participants. We also must think about the education of consumers in some meaningful way, to ensure that they know how to protect themselves. And I suggest we should adopt regulations similar to those that we adopted in Massachusetts , in terms of home improvement and mortgage abuses, as well as legislation relating to licensing. This problem won't be eradicated overnight. There is no magic panacea or simple solution , but if together, the banks, the mainstream lenders, responsible brokers, responsible home improvement contractors, local community, Federal and State agencies , for once engage in a partnership, and not to compete with each other, but work together to try to address these problems , we can have a public private partnership that I believe will change the urban economic landscape from one of deprivation and disintegration to one of hope and opportunity. And you, Mr. Chairman , are to be commended for your commitment to not simply hold hearings but to take action . And we stand ready and willing to assist in any way we can. Thank you very much. The CHAIRMAN . Thank you very much. That's very valuable testimony. I appreciate also the submission of materials from your work and studies. That will be very helpful to us. Next, Kathleen Keest, who is a consumer credit specialist with the National Consumer Law Center in Boston , and is also the author of the Center's study called "Second Mortgage Lending Abuses and Regulation ." We'd like to hear from you now, Ms. Keest. STATEMENT OF KATHLEEN KEEST, NATIONAL CONSUMER LAW CENTER, BOSTON, MA Ms. KEEST. Thank you for your invitation . Again , with everyone else , I'd like to thank you for focusing the attention on this . As you noted, others today are going to be telling you in graphic terms what the human costs of this phenomenon are. I'm here to be your boring speaker today, and tell you why I think some of these things have happened, and what I think can be done about it. One of the major contributors, we feel, has been deregulation. Usury rate ceilings have been around for thousands of years . They were around for a very good reason, that being that greed is unfortunately apparently an immutable human trait in human nature. Similarly, because there is inherent unequal bargaining power in consumer transactions, particularly consumer credit transactions, the regulation of consumer lending has been around for at least the better part of a century. But in the early part of the 1980's, when there was an anomalous mismatch between statutory rate caps and market rates, we threw the baby out with the bath water, and deregulated virtually everything, while, as Senator-I believe it was- D'Amato said, some States have nothing at all. Congress contributed as well . Not all of what we call second mortgages are really second mortgages . Some are first mortgages 257 which are also home equity loans . And Congress, in 1980, preempted State interest rate caps on those loans. That has contributed. Congress, in 1982, preempted any State regulations on some of the other creative financing things. Tricks that have been mentioned here, like negative amortizing loans and balloon payments. Along with the Federal trend toward deregulation, many States gutted their laws as well. This deregulation then set the unscrupuTous free to do what they will. The second thing that happened was the appreciation of real estate values. What happened was that there was an entire new pool of wealth created, and what we call the equity skimmers or equity thieves felt that it was there for them to, as Woody Allen put it, rob with a paper and pen. This led to what is called asset-based lending, which is OK in commercial loans, at least some of them, but when you're talking about consumers who look to their regular daily income to pay their loans back, it doesn't make any sense to look at the value of the collateral unless the House is going to write the check every month. It only makes sense if the homeowner is going to liquidate and if they have no intention of it , it doesn't make any sense to be making loans that these people cannot possibly afford with large balloons of large monthly payments . It just led to reckless underwriting because the lenders had nothing to lose while the borrowers had everything to lose. The third thing that happened was the rise of the secondary mortgage market, which helped a lot in terms of increasing the pool of mortgage money available, but it also made these people, these second mortgage operators, it gave them a backend income stream from which they could continue to operate. And it encouraged their reckless underwriting, because they didn't have to deal with the consequences. And the investors buying the paper felt that they didn't have to deal with the consequences because they could successfully or not. Ultimately, they felt that they could assert what is called the "holder in due course" doctrine to protect themselves, and separate themselves from any responsibility. We've talked a lot already about who this happens to . I just want to point out that one of the things we found from our national perspective is that in the areas where there has been the most permissive legal environments, regulatory environments, is where it's been worst, along with the areas where the real estate values rose most, like Massachusetts, Florida, the southwest. Then of course it happens most to the vulnerable populations , including the rural poor, as well as inner cities , rural Mississippi , rural Alabama, and of course, in addition, to the people who have no choices . I just want to make a point that a lot of times these loans got justified by saying that these were high risk borrowers. In the paper that Senator Riegle alluded to, we take issue with that. I simply want to make reference to that, rather than go into it here, that it's not really true that that's the real reason . 258 In terms of recommendations, there are a lot of recommendations that we've made in an appendix which is submitted with our written brief, which I'd ask to be made part of the record. The CHAIRMAN. Without objection. Ms. KEEST. Among the three most important are, one, reregulation. If you have a floating ceiling, that takes care of the problem of a mismatch, and it also concerns the problem that usury ceilings were around to serve for the last 3000 years. I would ask Congress not to preempt any States that want to do something even more protective. Second is to eliminate the "holder in due course" doctrine for consumer loans. And the third is to make improvident lending and equity skimming an unfair and deceptive or unconscionable act, and include a private means of enforcement. I see my time is up. I haven't heard any suggestions that this is going to happen today, but I do want to urge caution people. I know there's a lot of talk about regulatory burden . And when I hear the bankers talk about it, all I hear them mention is the consumer protection laws. And to gut those in the name of relieving regulatory burden is not going to help matters at all . There are a lot of other explanations, there are a lot of other reasons why there's a lot of paper work burden, and Truth-In -Lending is really not one of them. So I would urge you to not listen to that siren call. I want to thank you again for having the opportunity to testify. Like Mr. Harshbarger, if there's anything we can do to help the committee in its considerations, we'd be more than happy to do it. The CHAIRMAN. Thank you. Let me just say that those consumer protection laws are not going to be gutted by this committee, not while I'm here as Chairman. I can assure you of that. [Applause . ] Let me just say, that Mr. Terry Drent has given very important leadership in Ann Arbor, Michigan, for which I and others are appreciative. Further, he has actually assisted several homeowners with severe financial problems that have arisen because of these second mortgage abuses. Mr. Drent, we're pleased to have you and we'd like to hear from you now . STATEMENT OF TERRY DRENT, ANN ARBOR COMMUNITY DEVELOPMENT DEPARTMENT, ANN ARBOR, MI Mr. DRENT. Good morning, Senator. It's an honor to speak to this committee today, chaired by our distinguished Senator from Michigan. I'm Terry Drent of the Community Development of the City of Ann Arbor. Many people living on fixed incomes in Michigan and the rest of the country are facing a crisis. For many, the costs of medical care, housing, and basic sustenance is so high that people feel they have to supplement their incomes with debt just to survive. Many of these people are being preyed upon by unscrupulous mortgage companies, with a practice that we know as reverse red- 259 lining. These firms are targeting low-income families , claiming to be able to assist them in paying their bills. Many who avail themselves of these solutions find that they're worse off, and some are being actually forced out of their homes. People living on fixed incomes are most susceptible to the abuse by mortgage companies because they see their expenses increase more than their incomes. You know that if someone's income is derived from Social Security or any other COLA based program , the most it's going to increase is the rate of inflation , which has been about 3.5 percent a year over each of the last 4 years. In that time, we've seen medical costs increase by as much as 15 to 20 percent. The cost of home repair is also very high. Many people are also struggling to pay their property taxes on their homes, which have increased dramatically in recent years, as State and local governments continue to face budget imbalances , many due to Federal budget cuts . So people are in situations where they have to choose between buying food or perhaps paying property taxes or paying for health care or paying property taxes, or fixing a furnace in winter time or paying property taxes. Like most of us, they choose to pay for the things that will keep them alive, and they don't pay the property taxes. We've discovered that some mortgage companies study the delinquent tax rolls published by county treasurers, and these mortgage companies entice homeowners with loans to pay their back taxes and their medical costs . Frequently, the interest rate is double market rate, and there are many high administrative fees and points. One of the reasons these mortgage companies are successful in enticing people to accept these loans is that in Michigan and many States, if you are unable to pay the property taxes, the State will collect them by selling them at the delinquent tax sale . So a tax purchaser, frequently a company, will step in, pay the taxes, get a lien on the property, and start the process to take the home. Some of these companies also own mortgage companies. It's an embarrassment to me that Michigan is probably the worst State for this in the country. In Ann Arbor, we had an elderly widow with Alzheimer's disease who was unable to pay her property taxes , and subsequently they were purchased. A mortgage company contacted her through the delinquent tax roll and put a lot of pressure on her to sign mortgage papers, saying she'd lose her home if she didn't. They offered her a $35,000 loan at 18 percent interest. The CHAIRMAN. At 18 percent? Mr. DRENT. Yes , sir. When she actually needed 13 percent to pay her taxes. Her income was $770 a month derived from Social Security. This mortgage payment would have cost her $ 680 a month . She'd still have to pay her property tax bill . Now, that would leave about $ 90 a month to live on . So we worked with a local bank, Great Lakes Bancorp . And in consideration of the Community Reinvestment Act, they were able to extend her a loan for $ 15,000 at 9 percent interest. Her mortgage payment with her taxes is about $326 a month, and she's 260 going to be able to stay in her home. But not everyone is that lucky. There's another case in Southeastern Michigan where, again , an elderly widow with early onset of Alzheimer's disease couldn't afford her property taxes and medical bills . In 1989, she got a mortgage for $ 12,729 with a 3-year balloon payment. She defaulted. Her income was $520 a month derived from Social Security. Her mortgage payment was $350 a month. So she defaulted after 3 years. The bank refinanced . She defaulted again . They refinanced again. A third financial deal. In 18 months, her debt load increased from $ 12,729 to $39,500 . Of this increase, this woman only saw $4,066. The rest of it went to points and administrative fees. Right now, through a court agreementThe CHAIRMAN. They're basically just stealing her equity through those inflated figures. Mr. DRENT. Absolutely. It was clear that this woman could never pay this loan off. Right now, in the court agreement, she has 8 months to refinance or she's going to lose her home before the year is out, and truly become a burden on the community. This is a house she paid off once. She paid off her mortgage. There's another person in Ypsilanti, Michigan, who is mentally disabled . His mother left him her home so he'd always have a place to live. His State disability income equals $220 a month. A mortgage or a tax company bought his property taxes and exchanged the lien on his property for a mortgage at 25 percent interest. His payment is $250 a month, again , on an income of $220 a month. Right now, he's borrowing from friends and family to be able to live and pay this mortgage. He lives on about $25 a month after his payment. Soon, he will be one of our homeless mentally ill. There are many abuses in the nonconforming mortgage market. What once were considered usurious mortgages are now the norm. Many lower income homeowners are being victimized . The city of Ann Arbor isn't specifically against nonconforming mortgages. In fact, Mayor Brader of the city of Ann Arbor, and the City Council and the City Administrator are working with local banks to form a loan pool to help low- income people. However, we feel that there are consumer protections that can be put in place to protect the low-income, the vulnerable and the disadvantaged from an under-checked and under-regulated segment of the banking industry. We have some recommendations that I'd like to read into the record. We'd like you to consider repealing the exemptions from State usury laws in the Federal Banking Statutes. We'd like you to establish a Federal Usury Law, regulating interest rates as a specific percentage above prime rate and controlling the total financing charges imposed. Strengthen and clarify the notice of foreclosure prevention services existing in current law. Require personal notice of foreclosures to all significant interests in the property. Require judicial foreclosures of all mortgages. 261 And finally, amend the Older American's Act to require that lowincome seniors facing a foreclosure be referred to social service agencies that can help them, literally get in contact with programs that can help them. Now the problem is so severe in Ann Arbor and Southeastern Michigan, the Mayor and City Administrator set aside funds for a foreclosure prevention program. But we realized that we're putting a bandaid on an open wound, and regulatory action is needed. The practice of reverse redlining is threatening the sanctity of part of the American dream; that's homeownership. Right now, we feel that the rapacious dogs have been unchecked and under regulated, and are preying on our disadvantaged people . This activity is wrong, it's unfair, it's unAmerican, and it certainly needs to be stopped. And we hope that you take action to do so. The CHAIRMAN. Thank you very much. Thank you for your leadership in Ann Arbor and for coming today. Mr. Hamill is President of Fleet Bank of Massachusetts and a senior executive for the Fleet Northstar Group. He is the spokesperson for Fleet on the second mortgage issue . Mr. Hamill, we appreciate having you here. We'd like to hear from you now. STATEMENT OF JOHN HAMILL, PRESIDENT, FLEET BANK OF MASSACHUSETTS Mr. HAMILL. Thank you , Mr. Chairman . I appreciate being here. Senator D'Amato , I appreciate your comments and the legislation you are proposing. Senator Kerry, I appreciate your opening remarks. And Mr. Harshbarger, who I've worked with on a number of occasions . I'm pleased to be here. Fleet is headquartered in Providence, Rhode Island. We're the fourteenth largest bank holding company with $47 billion in assets . We have 1,300 offices in 42 States, and we employ over 27,000 people in our company with 5 major non-bank companies and 7 banks. Fleet Finance is in Atlanta, GA. That's the headquarters. It provides consumer finance services throughout Georgia and in 25 other States. It's one of the largest consumer finance companies in Georgia, but it's a smaller player in the national consumer finance industry. I would like to turn your attention, if you will, to the consumer finance industry as a whole , because it provides credit I believe to millions of people who would not otherwise be able to get credit. These are people who have low- and moderate- incomes, and who cannot obtain credit from traditional sources , such as banks and credit unions because of their existing credit problems. Fleet competes in this market with major national companies , such as Associates , AVCO Financial, Chrysler First Financial, Household International, Beneficial, Transamerica, G.E. Capital , the Money Store, Old Stone Credit, NationsBank, and many other companies. This industry provides credit to a segment of our country that needs credit. I believe that the industry needs to be focused on for what it does right, as well as what it does wrong. I would ask that we make sure that while we're looking at the question of access to credit, that we focus on the fact that people 262 do deserve access to credit, notwithstanding the fact that they have had a poor credit history in the past. That I think from a public policy standpoint is very very important. Senator DOMENICI. Would you state that again, please? Mr. HAMILL. I think that people, as a public policy matter, have a right to access to credit, notwithstanding the fact that in the past, they have had credit problems. I believe that that is what this industry has done and that certainly there have been abuses. But I want to make sure that we focus on the whole and not on the fringe. Home equity loans are typically used by consumers to reduce their monthly expenses by consolidating debt and stretching payments out over a longer term, when used right. A longer term and lower interest rate reduces the borrower's monthly payment, it eases cash flow problems. In addition , home equity loans are used to finance home improvements, to acquire personal property, to pay educational, medical, or other expenses . This is a new phenomenon , home equity loans. It is something in this country that we are dealing with, where we are bringing this to the consumer in a way that we've never done before. Congress allowed tax deductibility, as was pointed out. The fact is that we did have a rise in the real estate values, and the fact is that many people looked for a way to be able to access that equity in order to be able to satisfy some of their needs. I think that is a very important public policy decision that was made by this Congress, and I don't think it's something that we should retreat from because of the fact that we have problems at the fringe. We can take care of those problems . I would like to also say that, although the subject is not to be a Fleet Finance hearing specifically, you do have another panel, and I've read their testimony. And I think it's instructive to be able to at least talk to the industry issues that have been raised by Ms. Keest and others in the testimony that you will see, in order to be able to look at those issues through at least the eyes of Fleet Finance, as one company that does business in this industry. The first is that this industry makes loans at exorbitant interest rates. You might hear that. Also that excessive finance charges are part of this industry. I'd remind you that the loans of Fleet Finance that are presently on its books, and have been amassed over the last 7 years when rates were higher, and now have come lower, so that you need to look out or back over the last 7 years. Fleet Finance's Georgia loans , for example, have an average note rate of approximately 14.8 percent, and an APR of 15.9 percent. And I'm going to give you these statistics , and I will be happy to provide them to you with certifications and all of the documentation you need. Because I do not come before this committee lightly as a member of the Fleet Group, and give you statistics that I could not back up and prove to you . So I would mention that. Ninetyeight percent of Fleet Finance's loans in Georgia have interest rates below 21 percent . The CHAIRMAN . I'm sorry. Would you repeat that again? Mr. HAMILL. Ninety-eight percent of Fleet Finance's loans in Georgia have interest rates below 21 percent. 263 The CHAIRMAN. Let's have order in the room . Mr. HAMILL. We're talking about a portfolio of 20,000 loans , Senator, and I would like to make sure that we're looking at it through the eyes of the entire portfolio , in order to make sure that again you get the picture of this industry as a whole, not as a result of a piece of it. Last, on that point, 41 percent of Fleet Finance's Georgia loans have zero lender points. The CHAIRMAN . Say that again now. Mr. HAMILL. Forty-one percent of Fleet Finance's Georgia loans have zero lender points, and 98 percent of Fleet Finance's Georgia loans had 10 or less lender points. I give you that because it is often alleged that there are lender points in the 20 and 30 point range in this category. I'll get back to that. With respect to the allegation that this industry engages in home equity stripping , I'm sure that there are in fact some instances of that. We have heard those from Mr. Drent and others. But let me at least talk to that issue as it relates to the Fleet Finance portfolio in Georgia, because I think it's instructive. Usually equity stripping means that you have a lot of equity in the house and the loan is a very small dollar percentage of that equity, in order to be able to get at that equity. Eighty percent of the loans that Fleet Finance has made in Georgia have a loan to value in excess of 60 percent. That indicates that the loans that are being made are in fact substantial in relationship to the equity in that home , not low loans in relationship to the equity. Fleet Finance lost in Georgia $5 million in foreclosures in 1991 , $8 million in foreclosures in 1992, and nationwide, by the way, Fleet lost $24 million in foreclosures in 1992. And when it is often alleged that finance companies, such as Fleet, are in the business of making loans in order to foreclose on the loans in order to make money, I would be hard pressed to have that be a business that we would want to be in. In fact, at a loss of $ 24 million, it is quite to the contrary. The CHAIRMAN. Let me just stop you there. I take it, and you correct me if I'm wrong, that the loss that you just cited is on those mortgages on which you foreclosed and which you collected , versus what you have loaned against them. That, I assume , does not take into account the rest of the mortgages where high rates were charged, and the loan terms were fulfilled and there was profit from those. Is that included as an offset or not? Mr. HAMILL. These are the loans upon which a foreclosure took place, the loss on those foreclosures. And I'm addressing the equity stripping that says that you make the loan in order to be able to get the house and sell the house and make a profit. The CHAIRMAN. I understand that. Wouldn't it be fairer to say, to really evaluate the profitability of that class of loans at the higher interest rates, and you've given us those numbers , that you have to take all of the loans, those that payout and upon which you earn the profits, and those that default, upon which you've cited the losses . Wouldn't you have to take both sets of loans to really give a full picture of the profitability or loss of that sector of activity? 264 Mr. HAMILL. I think you obviously show that in the bottom line of the company, and what this addresses, and what your point, I think, goes to is the bottom line of the company. And yes, you can put those two together to see the bottom line of the company. The CHAIRMAN. I'm not talking about the bottom line of the company. I'm talking about the bottom line of that classification of loans. Because, in a sense, you're taking a part of the loans that in fact default and where you take a writedown because you've loaned money, and you wash those loans through, and you've posted a loss on the figures that you cite. I think what needs to be included at the same time is the profit on the other loans that are in that category of loan that are up at a very high level. To be fair about it, you have to do both. You have to talk about what the class of business yields in profitability or loss overall. Then if you want to take the part that has to do with the mortgage losses on those that don't pay out, I think that's appropriate to do . But you can't do one without the other, and give a fair picture. Mr. HAMILL. Your assumption, I think, Senator, is that all of the foreclosures take place on loans that are taking place at the higher rate. The CHAIRMAN. I'm not assuming that. I'm talking about these loans that go into these areas, where we think this problem exists . Mr. HAMILL. I would suggest to you that the foreclosures take place, as Mr. Harshbarger knows in New England , we have had, because of the poor economic climate over the last 4 years, many many thousands of foreclosures in fact. It had nothing to do with where the loan is made, in fact, but rather has to do with the fact that somebody lost their job, and we unfortunately in New England have had a terrific downturn in our economy, and had many people who have lost their jobs. It doesn't have anything to do with where they live. I think that is in fact part of the issue here, and not a question of the profitability of the piece of the business that is not foreclosed on. The CHAIRMAN. Let me ask you one other thing while we're on this topic. I'm interested in knowing, and you've got the data there with you, as an example you were using Georgia data earlier, the average outstanding interest rate on that class of loans you cited was 15.9 percent. Mr. HAMILL. That's the average of all loans in the portfolio. The CHAIRMAN. And you also said, just to keep the numbers clear, as to what I think I heard you saying, there's obviously some dissenters in the room, but you indicated that 98 percent of the loans were below 21 percent. Mr. HAMILL. Yes. The CHAIRMAN. I don't know exactly what the practices are in Georgia. I'd have to tell you, I gag on the theory that there's even one loan in 21 percent or 19 percent or 18 percent. I understand you can take the averages across the board here. [Applause . ] But correct me , if I'm wrong. If you get outside of GeorgiaSenator SHELBY. Mr. Chairman, can we have order in the hearing room? I think it's gotten out of control . We never have this in other hearings . We're all sympathetic to the people that are being 265 preyed on who have been exploited, but we do need order in the hearing room. The CHAIRMAN . Senator Shelby makes a good point. And it is important that we maintain order in the room. So I would ask that everyone respond to that. What I'm wondering is this . Is Georgia a State, that because of its State laws , that shows us a profile, even within your lending radius, and other States in which you operate, that would be different than we would see in other States. If, for example, we looked at your lending in Rhode Island, or we looked at your lending in Massachusetts, would we find average interest rates on this class of loans as high as the numbers you've cited in Georgia? Mr. HAMILL. Interestingly enough, the interest rates in Georgia are not dissimilar to loans that are made in other parts of this country. And Fleet Finance does business in 26 States in the country. So on the question of interest rates, you would see a difference , it was addressed by Ms. Keest and others , in the question of broker points and lender points. There would be more regulation in other States. Therefore you might see a difference there. The CHAIRMAN . Let me just stop you. So the 15.9 percent, if we were to take State by State in terms of the outstanding mortgages that Fleet has through the mortgage company that would be roughly comparable throughout all the States in which you operate? Mr. HAMILL. Roughly comparable. There would be some States that would be a little higher; there would be some States that would be a little lower. But roughly comparable. I looked back at the rate charts and the rate quotes that were used over the years by Fleet Finance in order to see what rates were, in fact, being quoted. Senator D'AMATO. Mr. Hamill-if I might, Mr. Chairman I am not going to be able to stay throughout. You have obviously reviewed this situation carefully as it relates , not specifically to one matter that's in litigation, but to the entire area. With the so- called "tin men" and others and people out there , the so-called independent contractors . What conclusion have you come to if any as it relates to how you, Fleet, are going to conduct your business activities now and in the future? I mean , I recognize that there are some very real horrors and that your institution has been involved by at least being lax and not seeing to it that some guy is getting ten points for originating a loan that the borrower has no chance of ever paying back. You recognize that, right? Yes or no? Mr. HAMILL. Senator, may I address the question? Senator D'AMATO . You recognize that there have been these egregious examples? Mr. HAMILL. We have recognized there have been problems, and we have taken steps. And I would like to address those if I might. Senator D'AMATO. Good . I want to hear what you have done and what you are going to be doing and what you recommend to be done. Mr. HAMILL. Let me take those in some order. 266 First off, we think that limiting broker points by State law makes sense . Senator D'AMATO . Shouldn't you be doing that? Mr. HAMILL. We have. Senator D'AMATO. Look, if you're paying some guy 10 points, he's going to be out there hustling like crazy. He's going to be selling these people-it's your responsibility. That's outrageous. How many points have you paid for a mortgage? Mr. HAMILL. As I indicated, we have-if I can give you the statistics again on broker points , it is I think instructive in regard to the issue of broker points. We have 75 percent of Georgia loans had zero broker points. Ninety percent had 5 or less . I would suggest to you also that Florida law, for instance, allows a combination of 10 points, 5 broker and 5 lender points, by State law. So if we were doing business, as we do in Florida, that's accepted . This is a question of State law. Each State has a different approach . We have taken the approach that notwithstanding the fact that 90 percent of our loans in Georgia-this is Georgia now- have 5 points or less, we will in fact adopt that as our policy. We will allow no broker to come to us with a loan who has charged more than 5 points. And I would also suggestSenator D'AMATO. But that has not always been the policy? Mr. HAMILL. No , it has not. Senator D'AMATO. When did you change this policy? Mr. HAMILL. We changed this at the beginning of 1992. But let me suggest to you, Senator D'Amato, that in fact in Georgia today there are plenty of lenders charging more than 5 points because in other States , by State law, you can charge more than 5 points. But we have taken the policy because, for the very reason that you suggest, even though we think that the problems that are here are the very edge, as I have tried to suggest, the very edge of some portfolios , we don't want to be subjected to the criticisms with respect to being at the edge of anything. So we have instituted a change in the way we do business , even though many of our competitors do not adopt that change . We also have a rate structure that we think is competitive in today's environment as well. The CHAIRMAN. Let me ask you this . Isn't it also an acknowledgement that you , in that category, you feel there has been an abuse? It isn't just to protect your good name, it's to protect your good name against a practice that I would assume you've decided in that area is abusive. If the costs get up to that point, it's a bad practice and it's one you don't want to continue; isn't that a fair conclusion? Mr. HAMILL. No , I don't think it is. But it is one I can see you logically coming to because it sounds-but we are, again, a major banking company. We have spent, and I think Senator Kerry has alluded to this, Mr. Murphy who is our Government relations office, who spends much time in New York , has spent enormous time in the field of community reinvestment. Ron Walker, who is here with me from Fleet Bank of Massachusetts , and many of the people in this room know him. We have spent billions of dollars in trying 267 to do what was just talked about, and that is to revivify some of these cities. I happen to live in Boston, and we are doing an enormous amount. Mr. Murphy lives in New York City. Others live in other cities . We are spending too much to try to do what you're trying to do, and that is help the inner-city, to be at any point criticized for something like this. So what we said is that our policy in effect will be 5 points , even though those points don't come to us. These are broker points that go to the broker. We are going to take the position that no broker that comes to us will be able to earn more than 5 percent, no matter where we do business , even though the State law allows more than that in other States. Senator D'AMATO. Let me ask you this. Should the State law be changed? Mr. HAMILL. I think that the issue of State law is, in my opinionSenator D'AMATO. Should there be a cap on brokers? Mr. HAMILL. I would suggest at least on the basis of the policy we have taken that we would support a policy of a 5 percent cap on brokers . Senator D'AMATO. Because isn't there something if you start getting above that 5 , isn't there something that's rather out of the ordinary? Mr. HAMILL. It depends upon the size of the loan , Senator. It depends on the size of the loan. If it's a $ 100,000 loan, yes. If it is a $ 10,000 loan, a broker will tell you that he's trying to help somebody get a loan who might otherwise not get credit. Five percent is not an unreasonable amount, he thinks, for the time and effort that he has. The CHAIRMAN. If I might Mr. HAMILL. You haven't allowed me all of my time. The CHAIRMAN. I want you to conclude. Let us save the rest of our questions . Senator KERRY. Mr. Chairman, if I may, I have an 11:30 I have to go to. Can the record remain open for submission of questions. The CHAIRMAN. By all means. Let me just ask Mr. Hamill how long he has. I want him to finish and we've interrupted him before he's finished. You should be given the chance to finish and I want to do that now. Senator Moseley-Braun wants to make a comment and others may as well. Mr. Hamill, why don't I give you-what do you need? Mr. HAMILL. I am not sure how much time I took, Senator. The Chairman. Why don't you take 2 or 3 minutes and then we'll go to questions. Mr. HAMILL. I would appreciate it. The CHAIRMAN. Senator Domenici, I will acknowledge you but I don't want to get into further discussion until he finishes. Senator DOMENICI . Mr. Chairman , I have expressed my views on the seriousness of the problem and I can't stay. But I want to suggest that the heart of this problem is redlining. Because if we didn't have redlining, there would be more money available in ordinary ways and I would hope that we really get to the issue. While this is a major problem, it is a residual problem to the extent of 268 I don't know what percent, 50, 60, 70 percent. Conventional bank loans don't have 20 points. If we can't get money into these areas, these kinds of problems are going to proliferate. The CHAIRMAN . Let me say, Senator Domenici , we are having a hearing on precisely that subject next week, because all of these issues fit together. Mr. Hamill, why don't you go ahead and conclude. Mr. HAMILL. I finished on that last number, the 90 percent of the brokered loans that we do business with on Fleet Finance had 5 points or less. Let me go on to the issue of foreclosures in general. It is often said that the consumer finance companies forecloseand at least it has been said about Fleet Finance on thousands and thousands of homes. The number is , in 1991 and 1992 , Fleet Finance foreclosed in Georgia on approximately 530 loans in each year out of 20,000 loans in the portfolio. The CHAIRMAN. 530 out of 20,000 in what quarter? Mr. HAMILL. About 2 percent per annum. And we have compared the 2 percent to the national average, and it is right in line with the national average. We have also looked at the race of the borrower upon which foreclosure has taken place, where we can tell that race of the borrower, because we don't always know what the race of the borrower is. But where we do know it, half of the foreclosures have been on people who are black and half have been on white. The CHAIRMAN. Do you have numbers prior to 1991 and 1992? Mr. HAMILL. They're smaller because the portfolio had been building up. The CHAIRMAN. Did the percentage go down too? Mr. HAMILL. It stays around 2 percent. But it is not enough to make a big difference because the denominator and the numerator both go up . The next point I would make is that it is generally argued, and I agree with Ms. Keest, that if there is a loan made where the debtto-income ratio of the borrower is out of line , we should never have made that loan . We have done some of those. They've gotten through. We buy some loans in bulk and we didn't do a good enough job. But let me give you at least a sense of what we have. Generally the criteria is the debt- to-income ratio should not exceed 50 percent. But 62 percent of our borrowers had debt-to-income ratios of less than 40 percent, 62 percent. Seventy-eight percent had debtto-income ratios of less than 45 percent, and 95 percent of the borrowers have debt-to-income ratios of less than 50 percent. If it is over 50 percent, there is either an explanation or an error. We have made errors ; we are not perfect. I can give you the percentages going up. But because we think very strongly that you have to be able to repay the loan, and as I mentioned the loan values here are not equity stripping, because we have made higher loaned values than has been alleged in the past. I would say to you also that our debt-to -income ratios here are, I think, a critical policy issue for you to think about. Representative Kennedy in the hearings in the House suggested that maybe there should be a 40 percent debt- to-income ratio as it relates to 269 the question of this issue. Mr. Harshbarger indicated that banks should have flexible lending guidelines. I have worked with the Massachusetts Affordable Housing Alliance and others to try to come up with those flexible guidelines. There is a question on the table. That is, how flexible should one be, and is it right to have a loan made on debt-to-income ratios in the 40 to 50 percent range? I say, yes, because as much of a tragedy as the foreclosure of anyone's house, and we hate it because not only is it a personal tragedy, but people lose money, I would say to you though that for the 98 percent of the people who could borrow that would not otherwise be able to borrow because of poor credit histories, who could not walk into a bank because of their prior credit history, it is most terribly important for them to have access to credit. With respect to the issue of targeting minority neighborhoods, I have given you the foreclosure numbers. Half of our foreclosures are against whites, half of our foreclosures are against blacks . If we were targeting, that would not be the case. We have stepped up to the plate, and I am going to finish by just saying what we have done. We have stepped up to the plate. I have said we do not want to be associated with any part of a fringe industry. We want to be in the mainstream. We have put on the table for those people who have been harmed in any way because of inadvertence, because we have missed some loans that are outside of our policy, that we have not done something that we should have done. We stepped up to the plate not because we have a legal admission of guilt but because we wanted to be good corporate citizens. And it has been thrown back in our face because we put a $38 million program on the table to help people that have had problems. It is thrown back in our face by class action lawyers who say we cannot institute that program because they want to bring a class action . We have offered to give a release to anybody who comes forward under this program in order to be able to make sure that they are not losing any legal right under a class action and we have been told, no, we will not allow our clients to deal with you. Now, before the class action lawyers got involved , we had been able to help 700 people who had been having a hard time making their payments and they have come to us and we have worked with them , and are willing to continue to work with them. Finally, I would say, that in terms of the recommendations , I like Senator D'Amato's notion of being able to give even better disclosure. I like the licensing issue with respect to the brokers so that you limit the points brokers can charge. I like stricter licensing of home improvement contractors because I believe that many times the problems start here, as Mr. Harshbarger indicated, with the home improvement contractor. I don't think that the banks and the finance companies can estimate values and that's what winds up having to happen when the loan is made, if the value of the home improvement isn't what it was supposed to be, it is impossible for the bank to be involved. Finally, I would say that as far as Ms. Keest indicated this, I think consumer education here and better disclosure is in fact, and I am not for doing away with Truth-In-Lending, in fact, the way 270 in which we this company discloses its loans under the Truth-InLending Act, we are all for it, we would like to see it enhanced, and we would hope with better education that will help. In fact, people who do not understand what it is that they are getting into. The CHAIRMAN. As we start the question period, I am mindful of the fact that we are moving along in the morning and we've got another panel coming. I am going to yield my question time initially to Senator Moseley-Braun who has not had a chance yet to make an opening comment. Let me just start with you and then we will go to Senator D'Amato , and we will go in the normal order. OPENING COMMENTS OF SENATOR CAROL MOSELEY-BRAUN Senator MOSELEY-BRAUN . Thank you very much, Mr. Chairman . I am going to ask that my opening statement- instead of reading it, I am going to ask that that be submitted for the record. Because, quite frankly, all the general things I was going to say in an opening statement have been overcome and overwhelmed by the testimony that we have heard . The CHAIRMAN. Without objection , so ordered . Senator MOSELEY-BRAUN . I am particularly taken by Mr. Hamill's testimony. That is most of what I have heard. And the apparent inability to understand how it is that what Fleet does and these other companies that we are looking at really has the effect of enforcing a tax on poor people. It is a tax that is all too often enforced on people who are black and brown. I listened to your remark when you said "half of our foreclosures are black, another half are white." The fact is that the AfricanAmerican population and the Hispanic population are, by definition, minorities. So you are talking about 50 percent of your foreclosures on 10 percent of the population , which is very different from 50 percent of 100 percent of the population. That has a disproportionate impact on people who are black and brown . The second point to be made that should just be very evident, and this gets in part to what Senator Domenici was saying, is that your company steps in where the majority of companies will not lend . We have already seen the HMDA study, the study that reported that black and Hispanic mortgage applicants in the Boston area are roughly 60 percent more likely to be turned down for a mortgage loan than whites. That's geographic redlining. But I want to submit that what we are looking at here is economic redlining as well, that it goes beyond just geography and that it really does go to people who literally have nowhere else to turn and they are preyed upon by companies that will make 21 percent because they can. That's what we are looking at is the situation in which people are subjected to lending practices because they have no options. There is something terribly wrong with that. And I would daresay, quite frankly, our failure to look at specific legislative solutions to this area which we have known about- I mean, this is not new news. It is just worse now because of the economic downturn that we've just come through . These practices have been going on for quite a while now. They have been exacerbated by the recession that we have just come out of, but they are not new. 271 Quite frankly, Mr. Chairman, I would very much like to hear from the other witnesses specific proposals for change, what we can do to fix this. Because 21 percent, you testified Mr. Hamill, that 98 percent of your loans were under 21 percent. It is terrifying to me what the other 2 percent might have been. But even more to the point, that is no benchmark when mortgage rates have not been in the double digits for over a decade. Second, I daresay without listening to your testimony you did not testify specifically in terms of your finance charges, your late fees, the time of turnover on these foreclosures, those kinds of things that are particularly hard for a family to deal with when someone loses their job, when there is a recession, or whatever. All of this in my mind, Mr. Chairman, comes down to a poverty tax. It comes down to an anchor, a weight, that we have failed to lift if we haven't been responsible for putting it there in the first place. We have failed to lift it on people who really have nowhere else to go. Literally the boats that are stuck at the bottom are stuck there in large part because of practices like this. I think we have an absolute moral obligation to move quickly on addressing specific recommendations for change and what we can do to make certain that this kind of activity ceases immediately . Thank you . The CHAIRMAN. Thank you. Senator D'Amato. Mr. HAMILL. Senator, I appreciate your comments, but if I might, just on a couple of points? One is the rates that I was talking about, that 98 percent are below 21 percent, are as a result of a portfolio in Georgia that has been built up over the last 7 years. Yes, the interest rates today are much lower than they were. But as you look back over the period of the last 7 years, you will find that in fact interest rates have come down substantially. So it is part and parcel with that. Today the interest rates are lower and, in fact, the rates that this company makes range from 9.9 percent up to, at this point in time, about 14 percent. It is a different rate environment. I am giving you a picture of a portfolio, not at a point in time. Senator MOSELEY-BRAUN. OK, Mr. Hamill. I was going to skip over asking all the questions that I had. But let's talk about that. You talked about an average interest rate of 14.8 percent. What is your high? Mr. HAMILL. As I indicated, there are 2 percent of the loans over 21 percent. The highest rate that I can see in that portfolio is I think a loan of about 28 percent or 29 percent. Again, it never should have been made . But when I look at those loans and I look back and wonder why those were made, those were mistakes . And I have said when you look at 98 percent or 99 percent of your portfolio being in what are, I think reasonable rate ranges , I am not here to say that we're perfect. But I am here to say, let's make sure we keep it in perspective. The CHAIRMAN. Senator, if you will just yield for one minute, if I may say, because I don't want that to pass , I think an average— I heard two numbers , 15.9 percent and 14.8 percent. Mr. HAMILL. 14.8 percent is a note rate, and 15.9 percent is an APR. 272 The CHAIRMAN. The annual percentage rate average. I have to tell you, and I appreciate the fact that you have changed your practices and you mentioned that today, so you are not doing things the way they were done in the past and you have acknowledged that mistakes were made along the way. I think that's direct and forthcoming. I've got to tell you that 15.9 percent on average as an APR bothers me. It bothers me and it ought to bother you, quite frankly. Mr. HAMILL. Can we speak about that, because I think it's a very important issue. The CHAIRMAN. We're talking averages right now. That means half of them are above that average. Mr. HAMILL. What I am trying to do is put it in perspective with the 98 percent in order to not just give you an average. Because I understand that averages can be misleading. Therefore , I am giving you the 98 percent below. In 1986, the rates of this company, not different from rates that were done by consumer finance companies-and this is not a fringe industry. The Household Finances and the Beneficials. These are companies that have been in business for 50 to 60 to 100 years . But the rates in 1986 ran from about 15 percent to 18 percent, depending upon the credit of the borrower. Now, I would say to you that if a person has a credit problem and a credit history that makes him unable to go into a bank and borrow, unable to qualify for a credit card and is able to bring down their monthly payments to a level that is affordable to them, and needs the money to be able to pay for something, whatever it is that they want to pay for, that is the going rate. I would say to you, I'd like to be able to lend to everybody at prime rate. But that is not the way the economic system works. The CHAIRMAN. I understand exactly what you're saying. But I think there is a part of the story that has to be added to that that's critical here. And if you don't add it, then it's a lopsided story. The fact of the matter is that traditional lending institutions have redlined certain areas of the community. We know this in the urban areas . The Federal Reserve has given us a study about discriminating against people based on race. And it is a very pronounced pattern . When somebody can't go and get a loan who is creditworthy in the normal system and they are pushed out of the normal system into this secondary kind of a system where the mortgage lenders who have been around for a long time, as you say, 15 to 18 percent, they're being price gouged because they are being denied credit where they should be able to get it and I understand how that system works. But I don't want to put a gloss of attractiveness on it or of acceptability on it, because it is very troubling to me and I think frankly it has hurt this country. Now, you've got to take both halves of the problem. The fact that there were rates out there at this level, 15.9 percent, that's the average. So you got half the people on the APR that are above that level . Or I should say half the average is above that level . Mr. HAMILL. Let me, if I might-these are second mortgages , these are not first mortgages . Although, as Ms. Keest said, some 273 of them technically are first mortgages. But they are not purchase money mortgages. These are mortgages that are in the truest sense of the word second mortgages. Second mortgages in banks, just as in finance companies, carry higher interest rates than they do with first mortgages. You cannot compare first and second mortgages. I am very familiar with the question of the redlining issue. But here is an industry, in fact, that is not redlining and I don't think it's reverse redlining. As we look at the statistics of this particular portfolio that happens to be Fleet Finance in Georgia, which has in Fulton and DeKalb counties a high percentage of people of color, I think it is usually viewed as a city that has done a great job with race relations by the way, and a model for many parts of the rest of the country . The fact is that our portfolio reflects a split along the lines of the population mix in Fulton and DeKalb counties. Therefore, I would say to you that, one , there is no redlining going on in this company. Second, I would say to you that the people who are borrowing, even if the banks were doing business in some of the neighborhoods where some of the people who are borrowing might live, the credit history of the borrower who comes to a consumer finance company does not make that person qualified for a loan. And I have dealt with this on the bank side. Let me put my bank hat on for a moment. We have struggled with this and Mr. Harshbarger knows that, Senator Kerry knows that. We have been pushed and I have tried to push to get Fannie Mae and others to take loans, and you have had hearings on this , that are beyond the traditional debt-to-income ratios that Fannie Mae would use or FHA uses and try to get them up if you will. They won't do that usually unless there is some kind of a subsidy that comes from the Federal Government. My point here is simply that these are borrowers, whether they be white or black, who are not able to go into a bank and borrow because of their credit problems. And I think they still, from a public policy standpoint, they deserve credit. They should have access to credit. And I think that the rates that are charged are reflective of the cost of the credit, the borrowing, and the servicing costs. The CHAIRMAN. If you will just withhold for a minute, Senator Moseley-Braun , do you have one other comment? Then I want to go to Senator D'Amato here because I've actually given you my time and I've interrupted you. Do you want to finish? Then I am going to go to Senator D'Amato. Senator MOSELEY- BRAUN. Thank you, Mr. Chairman . I am glad you asked the question about the high average. I wanted to specifically ask Mr. Hamill just on a small and very specific note, will you revisit that 28 percent mortgage and rewrite it for those people? Mr. HAMILL. In fact, we have a program—I don't know if you were here when I mentioned it. We have in fact on the table a $38 million program, $25 million of which is intended to do just that. We have said to people who have rates that got through our screen, come in and we want to do just that. 274 Senator MOSELEY-BRAUN. I don't mean them come in. If you know who those people are because that's in your portfolio, will you reach out to them and rewrite those mortgages? Mr. HAMILL. In fact, we have tried to do that. We have been thwarted by the class action lawyers from continuing to do that. I am more than pleased . We don't like the fact that that got through our screen. We're not perfect. We've said that we got 98 percent of our loans that we think at least have gotten through , but that's not acceptable, that 2 percent or 1 percent or whatever the number is that have gotten through the screen . We want to rectify that. So, yes we will. I would hope that I will be able to get through the legal entanglements in order to be able to do just that. Senator MOSELEY-BRAUN . Your points and finance charges , do you aggregate those? What are they? Are they aggregated and become part of this foreclosure package? Mr. HAMILL. As you know, the lender fees are part of the APR, so they are included in the APR. Senator MOSELEY- BRAUN. That's the 15.9 percent? Mr. HAMILL. That's the average , 15.8 percent. When I look at the portfolioSenator MOSELEY-BRAUN . I think you've got me where you got the Chairman a moment ago. It's 14.8 percent interest, 15.8 percent APR. Mr. HAMILL. And that goes to the question of the calculations under the Truth -In - Lending, which is the way in which we disclosed to the borrower what is the cost of the loan. As I mentioned to you, 98 percent of the loans that we make have 10 points or less . Senator MOSELEY-BRAUN. But what about your finance charges. and your late fees? Mr. HAMILL. Those are the finance charges the lender Senator MOSELEY-BRAUN . Do you have a separate category of late fees? Mr. HAMILL. On late fees we do. If I could ask one of my colleagues , I don't have a specific on what the late fee is . [Pause. ] It's usually 5 percent after 10 days , I'm told. I do not know that. Senator MOSELEY- BRAUN. Five percent of what? Mr. HAMILL. Of the payment due. If you owed that month $ 100 and you went 10 days, it would be 5 percent of the $ 100 ; it would be $ 5. The CHAIRMAN. If I may, I think I've got to now yield to Senator D'Amato so we stay within the time constraints here. Senator D'Amato. Senator D'AMATO. First of all , I have to say, Mr. Hamill, I hope you can continue to reach out, as you've indicated before , and Senator Braun has indicated , to those people who have been victimized and who have gotten through the process and through the system. And their counsel would do well to permit that, and they can continue their suit . But they should not be so driven by their own interests that they disadvantage people that can and should be helped. Second, it would seem to me that where you have built up tremendous costs at these kinds of interest rates, which are truly excessive, that there would be a forgiveness of those interest rates 275 that have accumulated, a certain forgiveness, a recognition that 28 percent or 25 percent or 21 percent is absolutely out of line. And certainly, in the cases where it can be clearly demonstrated that people would never have the ability to make the payments given their income, that that recognition should be taken into consideration so that it is not just a matter of taking a situation and saying, well, you owe us $50,000 with the accumulated interest, et cetera. Now we will just stretch it out and give you a new and lower interest rate. So I hope there is some kind of reasonable attempt to do that. Because I think that then demonstrates that you are on the cutting edge of doing the right kind of thing for the right reasons. And certainly don't question your motivations as it relates to that. I would like though, very much, because he has been a leader, to ask the attorney general, Mr. Chairman , Mr. Harshbarger-it's good to see him here I didn't think that earlier I would be able to come back and see you again, Scott, in this capacity. So I am delighted that I am able to be here to ask you that question . Someone else wanted to do that. What legislative remedies do you believe should be initiated on the Federal side? In our bill , we call for a Federal study, for example, of certain things such as should there be a cap on brokerage fees and commissions? I don't know whether there should or shouldn't be or what the cap should be. I think we should get the regulators to give us that information. But you have been a pioneer in this area along with Senator Kerry, your predecessor. So consequently, what would you suggest coming from the State side that you think the proper role of the Federal legislation should be in this area? Mr. HARSHBARGER. We made a number of suggestions. Many of them are geared to State regulation. But the biggest thing that we heard from all of the industry at various times was the lack of uniformity and consistency, that things would vary from place to place, and therefore those who chose to be unscrupulous could always fall back upon . It was vague, it was technical, it was overlapping, it was duplicative, there's too much regulation . And those who tried to comply were having difficulties. So one of the most interesting things for us about the regulations that we have the power in Massachusetts to issue under our consumer protection rates was we had long hearings with mortgage companies, with banks, with brokers, and the vast majority of the industry proposed most of the provisions that are contained in our regulations that have everything from fair and simple disclosure langauge, multilingual translation requirements, documents in other languages, interpreter services made available , assistance provided to people for mortgage transactions to issues such as how you do define APR, what points you can charge , what you cannot charge, what it should be. We suggested a cap on the rates that would be some percentage in excess of the prime rate. The details of those regulations addressed many of the kinds of problems that people addressed . And I felt consistently , Senator, that it would have been very helpful to 276 have had a Federal umbrella framework like Truth-In -Lending. We kept coming back to people saying, make it like Truth-In-Lending. The only point I want to make is not in defense of Mr. Hamill, but was that we found that if we could have had the protections applicable to banks available to the victims, we would have had remedies. That was the biggest difference . In this other world of consumer finance, the protections available under banking to banks were not available if you took your mortgages and loans from others . That was a very frustrating situation . A lot of our regulations and rulings were related to that. The second is your CRA looks that you're doing in terms of what is reasonable to expect of banks . But I would urge you to include in mainstream financial institutions legitimate first and second mortgage companies as well. There is no particular reason I could see that they should be excluded from these areas of regulation and control . Senator D'AMATO. Mr. Chairman, I want to thank you , and I certainly thank the attorney general for his comments and his work. Mr. Hamill, we thank you for coming forward today and making yourself available. Obviously I think you go a long way when you do indicate that there are certain abuses that have taken place. Now the question is how do we address and provide a remedy for those people who have been victimized, and what actions should we take to minimize future victims . I think Senator Domenici and the Chairman made a point. This is going to take place as long as there is not sufficient capital that can and should be made available to creditworthy people. I'll make one other aside. I don't believe, Mr. Hamill, I don't believe, and this is the genesis and the core of my disagreement with the administration and others when I proposed caps on credit cards, that everybody should be encouraged to borrow. I think it's wrong. I think it's absolutely wrong. When you get into this business and say, oh, well, look, people who are poor should be given credit. Let me tell you, if they don't have a possible chance of making the payments, you're going to enslave them, and it is wrong. Financial institutions should not do that. And then what you do is, you play-and I'm not saying you, but I'm saying this is the argument-you mean you would deprive people of credit that otherwise-you're doggone right. If a person is loaded up with bills , has got a family to support. Loan sharks do that. The guy's a gambler and he's desperate, and they say, OK, we'll loan you $ 1,000, and you've got to pay us x percent a day back . We're not helping people. And I'm not coming down on you, but I just heard that doggone argument from the last administration , from the banks that came out and said, oh, no, credit card interest rates are wrong, because you'll deprive the very people who need it most . That's nonsense. At some point in time, you've got to take a look and see, does a person, can they pay it back. And it's not wrong to say to them, we're not going to make it available to you. We'll work with you . So I just have to say, Mr. Chairman, we too have a responsibility of being able to say that in certain areas , if you make credit avail- 277 able to people that have no chance of ever paying it back, that is wrong. And I'll tell you, Fannie Mae shouldn't back you up, and Ginnie Mae shouldn't back it up, and the Government shouldn't back it up, because then what you're going to do is, you're going to have the taxpayers paying for those defaults . We've got to come to some kind of a reasonable balance in this. I thank the Chair. The CHAIRMAN. Thank you. Senator Shelby? Senator SHELBY. Thank you, Mr. Chairman . I believe this helps make a case before the committee for something you've had hearings on, Mr. Chairman, on why we need community development banks around to help people that are the most vulnerable , in ways in which they won't be exploited. I'm one Senator that's very interested in lifting the regulatory burden on banks in America in certain areas. But a case like today doesn't help that much. Because none of us are interested in lifting the burden on regulation if lack of regulation in an area is going to help exploit the most vulnerable of our people. A lot of these loans , a lot of these people that we've seen horror stories here and know about, a lot of people would be much better off if they had never taken a loan. If I were a lender, Mr. Hamill , I would be very very careful of buying loans from people in the market. You know, most lenders do, especially where they're second mortgage loans on older people and poor people. But there are horror stories here that we've read about where an elderly man 75, 76 years old has something done to his house . He has some remodeling done, with the money he receives from a loan and his payment exceeds his monthly income. If I were buying the loan as a lender, I would look at the credit report of the borrower. And if the loan called for 27 percent interest, or 22 percent interest, I would look at the ability of the borrower to pay back. I also wonder if there was fraud involved here. I don't want us to regulate lenders any more than they have to be regulated. But perhaps, if people are going to be exploited like this, this is an area that we're going to have to look into , nationally, and State by State. I'd be interested in the documentation . If lenders, finance companies, home remodeling companies, are unscrupulous in the way they get borrowers to sign up, I would like to see how. Is it the documentation? Are the papers fraudulent? Do people know what they are signing? How do we police this? How do you police it, if you were to buy these loans later? You assume that if you buy them on the market, that is what these borrowers assume, that everything is on the up and up. Many of these borrowers are desperate-perhaps they are elderly and in need of cash, perhaps they are simply uneducated and do not understand sophisticated loan documents . Some of our consumer protections are too sophisticated to actually protect consumers . We need to simplify the paperwork burden, both for lenders and for borrowers. 278 I hate to see Government micromanagement. But to protect our most vulnerable, the Government may have to get involved. Some lenders are obviously exploiting these people. I'm not saying whether you are or not. But why can't lenders police this problem in some way? If they can't, Government's going to step in. Do these people need access to credit? Obviously, they need access to credit. I would be interested to know, Mr. Hamill, since you are the spokesman and an officer, what is your profit margin in the area of second mortgage loans? How does it compare to credit cards? You know, the Senate reacted to credit card interest rates . I know there's a lot of credit card losses, but rates have been unreasonably high. It's also a very lucrative business ; we all use credit cards. I understand that. It would be better if each person paid his bill every month. Not everyone can pay his bill off each month. I would be very interested in seeing the profit margins of these businesses. Do you want to comment on that? Mr. HAMILL. I want to be careful. Generally the rates on credit cards over the period we're talking about have generally been higher than the rates over this last 7 or 8 years. We're into a lower rate period. Many times during the period , rates would have been higher on many of the loans that were being made in this portfolio. Yes, there are losses, but the credit card business has been a good business for banking over the years . It in fact has produced profits for banking. So I would say that in general, I would say that the credit card business has been more profitable for banks. Senator SHELBY. Than second mortgage lending? Mr. HAMILL. Than second mortgage lending. Senator SHELBY. What is the loss ratio in your portfolio, just being generic on second mortgage loans? Mr. HAMILL. The foreclosure rate, as I mentioned , in Georgia is around 2 percent. Senator SHELBY. The foreclosure rate is not always indicative of a loss though, because you've got collateral. A home, a piece of property, and there's equity in that home and you're looking at that as part of your collateral , are you not? Mr. HAMILL. Yes , we are. Senator SHELBY. And you recapture that? Mr. HAMILL. I'm saying, even after you go through the process of a foreclosure, nationally in this company, we lost $18 million , and in Georgia we lost $8 million. Senator SHELBY. You lost $ 18 million out of the whole operation? Mr. HAMILL. In the foreclosure process . Senator SHELBY. As an offset of how much profit though? Mr. HAMILL. Again , I think that the issue isn't profit. If you look at the company as a whole, it is a company that has generally provided about 10 or 11 percent of the Fleet Financial Group's earnings . As you well know, a higher percentage in 1990 or 1991 , as New England banks went through a terrible time, almost no profit this year in 1992. Senator SHELBY . But a lot of your own testimony on Fleet Financial's offices are located in Atlanta, GA, and they do a lot of business in the South, where I am from too, don't they? 279 Mr. HAMILL. In fact, we do business all over the country. We have, as I mentioned, the principal assets of the company, if you will, though, are the banks in New York and New England. Just on an employee count basis, if you will, there are 27,000 people who work for Fleet Group throughout the United States. There are a thousand people who work for Fleet Finance throughout the United States. So 27th of the employee count of the whole Fleet Group of all companies is made up of the people in Fleet Finance. Senator SHELBY. Let me ask you a question like this. Assume you make a second mortgage loan to me, for example. And I have a home in Tuscaloosa, Alabama, which is my home. And whoever, if I'm dealing directly, you'd go out there and do at least a windshield appraisal of the house and the property for a second mortgage loan. You'd check to see if I have a first mortgage lien on the property, and how much it is. That's part of doing business in making a second mortgage loan, is it not? Mr. HAMILL. Yes, it is. Senator SHELBY. For example, if I had a piece of property that might be worth $ 100,000 on the market, then I owned say, $ 10,000 or $15,000 on an old mortgage that I was paying off on my home, which is typical, and you came in and loaned me $40,000 to fix up the house, so to speak, and give me some walking around money or whatever, you're looking at the equity in that home that you're protecting yourself by making that loan and putting up the mortgage on the equity. In other words, you'd be fairly well covered, wouldn't you? Mr. HAMILL. I think the most important point, thoughSenator SHELBY. Isn't this important? You make a second mortgage loan because you believe that it is relatively safe ; a loan on a person's home, when they have equity there, is relatively safe . Isn't that part of the criteria? Mr. HAMILL . SenatorSenator SHELBY. Answer my question . Isn't it part of the criteria? Mr. HAMILL. It's part of the criteria. The first criteria, though, is whether or not you have a job and whether or not you have the income to afford the loan that you want. Senator SHELBY. What about some of these horror stories where a man who is drawing Social Security and had equity in his home, but the loan payment exceeded his monthly income. It looks like a credit report would pick that out. And if you were a prudent lender, you wouldn't loan. Mr. HAMILL. It shouldn't have been done. As I indicated, we are not-and, again, I go back to the statistics in this company with respect to the debt-to- income ratios that have been used in making the loans-62 percent of the borrowers in this company have debtto-income ratios below 40 percent. The general criterion is to not go over 50 percent. We've gone over that. Sometimes somebody has got some other assets . Sometimes it's a mistake. We buy loans in bulk. Senator SHELBY. Let me ask you this. Let's assume that same scenario a minute ago . Let's say I or anybody, these people in here from Georgia, let's say they had a home that had $ 15,000 owed on 280 it. The property you appraised was $ 100,000 . They wanted to borrow $25,000. Do you take in the amount of equity in that house, the risk when you formulate the interest rate they are going to pay? Or do you have a standard interest rate for a second mortgage loan? Mr. HAMILL. The better the credit of the borrower, you want to make sure, first off, what the credit of the borrower is. That person's going to get the best rate. Senator SHELBY. And is part of the credit the collateral? Mr. HAMILL. You're going to look at both the income of the borrower and the collateral. Senator SHELBY. How important is the collateral? Mr. HAMILL. It is of secondary importance. It is not of primary importance. It is clearly a piece of collateral that we don't want. Senator SHELBY . Without the collateral, you wouldn't make the loan, would you? Mr. HAMILL. The second mortgage business has grown up in this country, as I indicated, because of the fact that people wanted access to the equity in their homes to be able to borrow. But the most important thing in our case is, every time we foreclose on a home, it is both a personal tragedy and it is a loss to us. We lose money through the process of foreclosure. Senator SHELBY. You don't always lose money, because if the collateral is there, you don't lose money. Mr. HAMILL. In other words , my point is, though, as I look at the entire number of foreclosures that have been done, there may be some that there is in fact enough equity to cover, but when I look at all of the foreclosures, we lose money. The second thing is, the foreclosures that have taken place since I've gone back and looked at the records, the reasons the foreclosures have taken place has generally been because people have lost their jobs , because of the economic conditions. Senator SHELBY. Why do people in the lending business-I know you've got great folks, and I assume you're one of them, I just assume that- but why do they gouge and exploit the most vulnerable people in America? Mr. HAMILL. I would suggest, Senator , that they do not. Senator SHELBY. But there is evidence that they do . I don't say the overwhelming majority of evidence. There is evidence here, sir, that there is overwhelming exploitation and gouging when you're charging 28 or 29 percent or 24 percent to the most vulnerable. There's a lot of fraud there. I'm coming at you with an idea to deregulate, but you can't deregulate this kind of stuff. Mr. HAMILL. I'm not suggesting that you deregulate Truth - InLending. I'm not here to say that. Senator SHELBY. Truth- In -Lending sure didn't help these people , because a lot of them didn't understand that. Maybe it wasn't explained to them. Mr. HAMILL. That goes to the question of education . I'd make two points . One is, I have not, and I'm sure you've seen a lot of different entities, whether it be businesses or other kinds of entities , I've found no entity that is perfect, but as I look at the portfolio of this com- 281 pany, I am saying to you that we have a very small number of people where we missed it. We bought a package of loans and we didn't do the job, but it's a very small. I would urge you, as we talk about this, that we have 98 , 99 percent of the customers that are being well-served, and I want to make sure that 100 percent are. And we're taking all the steps we can. We've taken further steps to change the way in which we buy loans. We're dealing directly with the broker now, even though the business is generally done through correspondence. Senator SHELBY. I know my time's expired, but shouldn't you bend over backward when you're dealing with the most vulnerable of our population , those that are under educated people, those that are desperate for money, not to exploit them? Mr. HAMILL. Yes, I agree with that. Absolutely. We have, as a company, and as I indicated earlier, we're spending billions of dollars trying to help rebuild the cities of America. That I would suggest to you indicates that the ethical nature of this company is high. Senator SHELBY. But you don't want to rebuild it on the big profit margins you make off of these people, do you? Mr. HAMILL. Not at all. What we want to do is make sure that if there is an error, that we correct it. And we're taking those steps. Second, I think we want to make sure that in the context of this business, that it is done without having to come to the Federal Government for subsidies in order to make it work. And if it means that we cannot provide credit to people who are at the upper end of the debt-to-income ratio , then we will not. Those people, going to Senator D'Amato, and perhaps your comment also, maybe there are people who should not be borrowing here. We thought we were doing that by limiting the debt-to-income ratio in this company to 50 percent. Maybe it should go down lower. We will do that if in fact that seems to be the way in which we can best get to the issues that you're talking about , because it is not worth our effort and time to be in a business where , even though it might be doing some good for an individual who would not otherwise be able to borrow, it's not worth it for us to be accused of trying to rip off people. So we will move that down the scale, and make sure that we are in fact not going to be accused of that in the future. The CHAIRMAN. Let me just say on that, Mr. Hamill , we're going to help you do this. [ Laughter . ] That comes to the point, too, where you've got to put your banking hat back on. Because we think the banking side of a lot of major entities in this country who enjoy Federal Deposit Insurance , and access to the Fed window and other certain Government granted assets and help, have to do a better job of coming in there through the normal lending institutions. You're here in a dual capacity and you've explained that, and we understand that. I think, if the normal banking system were doing a better job, I mean, the education problem here isn't just educating people in the inner cities, it's educating people that run a lot of these financial institutions, isn't it? 282 Mr. HAMILL. I would say, Senator, that we've all, as we've spent more and more time in the inner-city-and I am one who has done a lot of that-understand that we have to try to go to great lengths in order to bring the resources of the financial institutions to the inner-city. And we have worked, as you have, with Fannie Mae and others to try to make that happen. The CHAIRMAN. We're going to do more in that area. Mr. HAMILL. The President of the Fed testified before Representative Kennedy. He said the balance here is the balance between access to credit and appropriate guidelines. We're all searching for that. We do it in the banking business through ratios , debt-to-income. They're not perfect. We're not saying they're perfect. But they are proxies, the best proxies that we know. We're trying to make sure that nobody tips over here, that nobody goes through. People do get through the safety net. We're here to try to help them if we can, and that's why we've put this program in place. And we're here to work with you in order to get that right balance . The CHAIRMAN. You've acknowledged today that you've changed the practices within the institution. You've made changes in your practices. Mr. HAMILL. We have, even though our competitors have not changed, to be able to be sure that we are at the leading edge of trying to make sure that people don't slip through, because they have. You will hear testimony from Mrs. Diggs. That loan should never have been made . And we bought it in a package, and I'm sorry that it ever got through the package. But it's not representative of this portfolio. The CHAIRMAN . We'll get to her very shortly. Senator Boxer? Senator BOXER. Thank you very much, Mr. Chairman. Mr. Hamill, I really appreciate your trying to put the best light on some of the things you've done but some of your comments disturb me . You said that maybe there are some people who don't deserve credit, you said this as a kind of veiled threat. Mr. HAMILL. No. Senator BOXER. Excuse me, sir. You'll have a time to respond . Not a direct threat at anyone, but sort of a veiled threat from the industry that if we don't lay off then no one will have any credit. That was what I heard. Maybe you didn't mean it. I'm telling you that's what I heard when you said, I believe, "this isn't worth it ." Well, you're darn right it was worth it. You're talking about a portfolio that averages 15 percent and some loans as high as 28 percent. It was worth it for Fleet . You have a very small default so sure it was worth it. And, you know, we're not perfect. I say that a lot. I'm not, you're not, no one is. But this is the business you're in so I don't accept the explanation that these high percentage loans got through your screening process . 283 How could you let a 28 percent loan get through the screening process? What did you pay for that money that you're charging 28 percent? What did you pay? Nine percent, 8 percent? Do you have an answer? What did you pay for that? Mr. HAMILL. If I might, the year in which that loan was made, I would estimate that the cost of money would have been in the 8 or 9 percent range. Senator BOXER. Eight or 9 to 28 percent, and it got through the screening . I'm not a person that likes to set caps on things, because I come from a free market economy. I was a stockbroker. I don't like to set limits. But I think what Mr. Shelby was getting at—and I know he doesn't like to do it either-is that in the face of such outrageous behavior it's almost impossible not to consider having the Government impose some limits. Is there no shame here? Is there no conscience here? I have a lot of problems with the way Fleet conducts business . Now how many homes did you actually take over that defaulted and then were sold? Mr. HAMILL. Five hundred and thirty in Georgia in 1992 and 1991 , on a base of 20,000 loans. Senator BOXER. You took over 530 homes and on most of that, I assume, you made a profit? Mr. HAMILL. No. As a matter of fact, the loss for 1992 was $ 8 million. Senator BOXER. What about all the other homes that you took over and sold? Mr. HAMILL. That's it. I'm talking about the losses on the 530 loans. Senator BOXER. How does that compare to the profits you made on the other loans that did not default, which is something we're trying to get at here , and we haven't been able to succeed so far. Mr. HAMILL. The issue, I think , is the bottom line of the company. And the company, I don't want to use 1992 because it was a bad year for the company , on average, it has made in the $30 million range bottom line on average. I would be happy to provide you each of the years, and what that represents as a percentage of the total of the Fleet Finance Group's bottom line. But let me address the veiled threat, because that was not my intention. I was trying to respond to Senator D'Amato's notion that there are some people who shouldn't be borrowing, and that the lending institutions should in fact take the initiative to be sure that they don't borrow because they get in over their heads , and they lose their homes. Senator BOXER . No one should borrow at usurious rates . That's true. Mr. HAMILL. If I might, though, these are not usurious rates. Senator BOXER. That's debatable. Mr. HAMILL. I would suggest to you that in this country today there are 15,000 companies that are in the second mortgage business. This is a highly competitive business. The rates are in fact set through competition , just like stockbroker rates are set , just like any other business' rates are set. We don't control this market. 70-832 0 - 93 - 10 284 I would only urge you then to not think about them as usurious rates, but rather the rates of the industry. Senator BOXER. Sir, I'm sorry. We're allowed to filibuster in the Senate. You know, you filibustered because that little light's going to turn red . And I just want to make one more comment. Mr. HAMILL. I apologize. Senator BOXER. Unfortunately, I've waited 2 hours and I can't wait any longer, because I have to meet some young people who are meeting here. I'm sure you're very sad to know I'm leaving. [Laughter. ] But on the next panel one of my constituents from California is going to tell a story that will make everyone just sick at heart. This is somebody who was preyed upon. So I would urge you to tell your colleagues in this very competitive marketplace where it's all dog eat dog, not to send people out knocking on doors saying, gee, the step on your front porch is broken, and I can help you with that, and I can consolidate all your loans . All for the purpose, in effect, of destroying that person's life. There's got to be something that stops that from happening now. What I'm suggesting is that there should be a new ethic. Maybe it's a new time that we need to be more responsible for everyone who's a part of our organization. Fleet needs to step up and accept responsibility. And you alluded to that. I would hope that you would take immediate steps voluntarily to change that. I know you're trying to do that. But, as Americans, we can't allow these practices to continue. Mr. Chairman , you've been very patient. I thank you and I will work with you on this issue. The CHAIRMAN. Thank you very much. Senator Sarbanes. OPENING STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANES. Thank you very much, Mr. Chairman . I apologize to the panel that I wasn't able to be here earlier to hear the testimony, but I had another hearing at which I had to be present. First of all, Mr. Chairman, I want to commend you for holding this hearing. This is one in a series that the Banking Committee is holding this month on credit availability for borrowers in the low- and moderate- income areas in the country. We held a hearing on February 3, 1993 , on community-based lending institutions, such as community development banks, community development credit unions. Next Wednesday, we have a hearing, as I understand it, on racial discrimination in mortgage lending. I feel very strongly that this is a very important public service which the committee is rendering. And I particularly want to go on the record in thanking you for your leadership in this regard. I think there are a number of problems here. My colleague, Senator Shelby, indicated that this underscored the need for the community development banks . 285 I think it also underscores the fact that a lot of commercial banks are simply redlining out areas, and not making loans available, loans which, in many instances, ought to be made. And their refusal to do so, and the unavailability of credit gives an opportunity for others, often time less reputable lenders , to enter the market and take advantage of unsophisticated borrowers. In some instances , you have mainline financial institutions who won't do it directly. But then they set up subsidiaries in order to do it, in order to be able to exploit that market. This apparently is particularly true in the area of home equity lending, which for many low- and moderate-income people is their only source of personal wealth, is the equity they build up in their homes. Then, to finance needed improvements or other needs, they borrow based on the value of their home equity. They encounter difficulty getting credit from conventional commercial banks. They turn to second mortgage lenders or finance companies . Then they get loans at extraordinarily high rates of interest, and in many instances, it appears from the face of it on the record that the borrower is really going to be unable to service the debt. It's obvious on its face, when the loan is made. I want to just put a couple of questions. First of all, Mr. Hamill, you make money on the second mortgage lending, don't you? Mr. HAMILL. Yes, sir. Senator SARBANES. So the failure to make money was in reference to those instances in which you actually had to go to foreclosure. Is that correct? Mr. HAMILL. Yes, Senator. It was in response to the question that was raised earlier about whether we were, as an industry or a company, strip mining the equity out of homes, trying to in effect make the loan knowing that the people could not pay back the loan, hoping to get the house and then make a lot of money on the sale of the house. Senator SARBANES. But what you're doing to the others on whom you have not foreclosed is, you're absolutely pressing them to the wall. Here's what happens. In some ways , this is a tremendous testimony to the responsibility to meet their obligations of low- and moderate-income people. That's one of the readings I take out of your testimony, because here's what happens. They take these really high rate loans, exorbitant in the eyes of many, including my own , I assume. Then they're pressed, and they go to every possible effort to meet the loan payment. Let me ask you this question . If I take that into account, let me accept your testimony now, the factual statement you've made, that on the actual houses on which you went to foreclosure, you lost money. And you said that was 2 percent of the houses. Mr. HAMILL . The number of foreclosures that were effected in 1992 and 1991 represented about 2 percent of the total portfolio. Senator SARBANES . So you have the other 98 percent of the portfolio made at these high interest rates . People doing everything they possibly can to meet those payments, which are really putting it to them. Now you made money out of that 98 percent, didn't you? 286 Mr. HAMILL . Yes. Senator SARBANES. You made so much money that it more than offset the losses , did it not? Mr. HAMILL. Yes. The foreclosures are a part of the operations of the company and they're not synonymous with the profits of the 98 percent. Senator SARBANES. Why are we looking only at the profit and loss on the foreclosed properties, and not looking at the profit and loss on the total picture? Mr. HAMILL. I agree with you, Senator. I'm only trying to respond to the issue that keeps coming up, that there is, in effect, an underlying business inside of the entire business, and that the underlying business is one of trying to make money on foreclosures. Senator SARBANES. Maybe you're making money on the threat of foreclosure. Maybe when you actually go to foreclosure, in that instance, you then don't make money. But the threat of foreclosure is absolutely pushing these people against the wall. And therefore not to lose their home, in order to hold onto their home, it's the only thing they have, the only thing they've worked all their lives to build up, and not to actually lose it , they're going to an extraordinary extent to produce the money to make these payments . Isn't that a reasonable hypothesis? Mr. HAMILL. Senator, as I've indicated before you came in, in New England where I live, we've gone through an extraordinary economic downturn over the last 4 years. We've had literally thousands of people who have lost their homes because of the fact that when the loan was originally made, the income of the individual in relationship to the debt they took on was reasonable, but they lost their job. I would suggest to you that we have, as a matter of policy, had debt-to-income ratios, again 62 percent of the borrowers had debtto-income of less than 40 percent. It's perfectly reasonable in terms of their ability to repay. And if a change in circumstances takes place, it is going to put people into a position as it did with many of our friends and colleagues in New England. Senator SARBANES. What's your return on the subsidiary? Mr. HAMILL. In 1992, it was very poor because of a variety of one-time events , but in general, the return on equity is in the 17 percent range. Senator SARBANES . And what's the return on your regular commercial bank? Mr. HAMILL. Again , I don't want to use the last couple of years, because of the fact that there have been, in New England, enormous dislocations, but the Fleet Banking Group, if you will, in normalized times has been in the 17 to 18 percent rate of return range. Senator SARBANES . You're including, now, the secondary mortgage excluding that, your regular commercial operation . What is your return on that? Mr. HAMILL. It's in the same category because this represents, on a normalized basis, again , taking out the bad year that this company had in 1992 , and the bad year the banks had in 1990 and 1991 , it represents about 10 percent of the total of Fleet Financial 287 Group, so that the returns of Fleet Financial Group, excluding this, are about the same as the returns from this company. Senator SARBANES. Let me ask the other members of the panel. Maybe I'll come to you, Ms. Keest, what do you think about this hypothesis of mine that it's the threat. It doesn't really get to the point to simply look at the actual foreclosures without looking at the threat of foreclosure. And the company, in a sense, over lending on these houses , knowing that people are going to do everything they possibly can not to lose their house, they're going to be paying these very high rates of interest, they're going to go to extraordinary lengths not to do so. So they've got something working here, I mean , they've got this threat of foreclosure and it serves as an incredible pressure. In fact, if some people are not actually lost with these tragic stories, I don't know that the issue would have ever gotten the profile that it's now getting. And this practice then would have continued, but it never would have come so clearly to public attention . So what about those people? I don't know where they're finding it. I guess they're taking it out of food and clothing and heat and everything else, in order to meet these payments . Ms. KEEST. Or refinancing with other ones of these high-rate lenders . Absolutely. I think originally when we started talking about this problem_we did talk about equity skimming as trying to get the property. But as we began to see more of it, we began to think of it more broadly, which is that the ones who pay, that's a transfer of wealth from the equity to the lender and the ones who don't pay, it's a transfer of the property. Either way, the increased equity gets to the lender. Even one of the worst of the examples in New England which I understand had about a 40 percent foreclosure rate, that was 60 percent of those people who paid. I also want to make a point that to further complicate matters, when they talk about what the losses are, and I cannot speak to Fleet Finance's practices in this regard, but I know that in some of them in New England, if they talk about a loss on a foreclosure, they may be talking about saying we didn't get to recoup the principal that we expended. But a lot of these lenders, on top of charging 20-plus percent interest, were what we call loan padding, which is the note principal may say $ 20,000 and $ 15,000 was only their actual expenditure; $ 5,000 of it was smoke and mirrors. So if they say they lost that $20,000 loan on foreclosure, they didn't really lose $20,000 because $ 5,000 of it was just another way of doing some equity skimming. Senator SARBANES. The other thing, of course, is that you pay a high enough interest rate and the loan lasts for a while. The lender can recover through the interest. He is doing pretty good even if he loses on the principal when he finally goes to foreclosure. Isn't that correct? Ms. KEEST. Absolutely. One of my favorite schemes in some of the New England ones was the ones where they would make loans where they were bound to go into default very early. Then the note called for a 42 percent default rate. 288 The CHAIRMAN. Would you just yield to me? I see another problem here we haven't really illuminated yet today. I want to leave Mr. Hamill out of it, so this isn't aimed at your company here. But it is aimed at companies that are holding companies where they have banks, traditional banks, then they've got these mortgage finance operations as separate entities under one corporate structure. Let's take as an illustration the portfolio you spoke about in Georgia, where 98 percent of it was up to date, even though the interest rates were high and so forth. Only 2 percent were in foreclosure. The other 98 percent are functioning in the normal fashion. Let's leave Fleet and just go to a bank with a holding company like that. If 98 percent of those loans are going to pay off and they are going to pay off at a high interest rate, you've got an opportunity because you can wear different hats . You can either be a traditional bank, you can go into the inner-city and you can make the loan to the inner-city borrower, let's say, at 7.5 percent. Or you can decide, no, you're not going to make the loan to that person at 7.5 percent. You'll go over here to another party or company and you'll make the same loan to that person at 15 percent. And you obviously believe in anything like a 98 percent success ratio would let you believe that that borrower could afford to pay 15 percent. If they could afford to pay 15 percent, don't you have even a more secure loan if they're only paying 7 percent, because you're not squeezing them to the wall like Senator Sarbanes has just talked about? I can see a very perverse incentive in a holding company here. I am not saying that's true in this instance. I don't know if it's true; I don't know if it is or isn't. But I can see why the economics if you've got a class of borrowers that are going to pay up 98 percent of the time, you can run them through the mortgage mill at 15 percent rather than 7.5 percent, why would you make a loan at 7.5 percent? You just sort of take a look at it and say, well, that's a tough area and, you know, I'm not sure I really want to bother with that kind of lending, and so forth. We won't do it through this window; we'll go over here and do it through a different window. We will take off our banking hat and put on our mortgage banking hat and we'll go out and we'll find that same borrower is now suddenly and magically creditworthy at a 15 percent rate. And we are going to have a 98 percent payback. But that person who would find it easier to pay back if they were only paying 7.5 percent is not creditworthy. Part of the problem here is I think we've had the financial system functioning in a way where we've had large parts of our society sort of ruled out of bounds for normal lending. The traditional banks, in many cases, have bailed out of the inner cities . In fact, in many cases you can't even cash a check. You've got to go into one of these high priced check cashing operations even to cash a Government check in a lot of inner-city locations . That's just not right. But the fact of the matter is it seems to me that you've got a situation here where if you've got a holding company, there is a built 289 in financial incentive, if you've got a good base of customers out there who are going to pay back 98 percent of the time and it is a highly profitable business, why would you go ahead and finance them at 7 percent if you can go ahead and finance them at 15 percent? Doesn't that logic hold together, Ms. Keest? Ms. KEEST. Yes . I think it is called steering-the- sucker sales . You alluded earlier to a paper that I wrote and there is an appendix in there in which I had read a Law Review article that was conducted resulting from testing using paired testers of people shopping for new car loans. As I read that article, it really struck home to me on this whole issue of high- rate lending. — And what they speculated was what they found was controlling for everything else, white women paid 48 percent bigger markups on new cars than white men. Black men made twice the markup, black women paid three times the markup. What they speculated the reason was is that not all the that the profits from the sales were not spread evenly on all sales. So what they did, there were stereotypes operating as to who the salespeople thought would be the suckers that would pay full markup. I would speculate that if I went into, for example, a finance company-this doesn't get to the holding company but it is the same sort of issue-and asked or was applying for a loan, they would not try to pad my loan. They do pad my clients' loans. The CHAIRMAN. Wouldn't a holding company have exactly the incentive I talked about, Mr. Harshbarger? Mr. HARSHBARGER. Yes. And I think in certain respects , a lot of our investigation documented that this was occurring, although the form in which it was occurring was through the second mortgage companies, like Resources Financial, which were selling packages to the banks. That was the original phenomenon that was being utilized most of the time, according to our investigation . An investigation clearly documents almost every point that both you and Senator Sarbanes have made about this issue. One of our arguments about the flexible criteria had to do with the fact that most people were paying these rates. That was what was incredible to find. They were willing and able to try to meet these rates. Somehow, the criteria ought to meet that level of credit worthiness as opposed to something else. The CHAIRMAN . And they would actually be a better credit risk if they were paying a lower rate of interest because they wouldn't be squeezed to death. Senator Moseley- Braun . Senator MOSELEY-BRAUN. Thank you very much, Mr. Chairman . I am going to be brief because we have a conference on the President's proposals coming up. But I really want to reiterate and to thank you for calling this hearing. I have been on this committee now for the month that I have been in the Senate and we have had hearings now on credit availability, this hearing on reverse redlining, and these kinds of financial practices . You have really done a yeoman's job to bring and make the Banking Committee relevant to the concerns that the people have. I thank you for that. I want also to say to Mr. Hamill I think part of the problem, and I don't know the people in the audience really can't see Mr. 290 Hamill's face . He looks so stricken. He looks like he really-his feelings are hurt. Well , you do . I think part of the problem is that not only is he having to talk about Fleet's practices, but the practices of the rest of the industry. It is the industry that is the problem. It is the fact that we, the lawmakers, have not put the kind of regulation on this industry that it absolutely needs to have. That, in my opinion, is the problem. The fact that people are being preyed upon , these horror stories someone sent me. I don't even know whose paperwork this is. But someone sent me some paperwork, Mr. Chairman. I was sitting here trying to calculate up the numbers and referring to your comment about loan padding, Ms. Keest. I am looking at the numbers here. This individual received $ 10,000, had a note for $ 12,500, and paid about 20 percent in fees and charges, putting aside for a moment the 22 percent interest rate. I mean, it is nothing short of outrageous. Mr. Chairman, I just wanted to say, and I don't know whose documents these are, but I want you to get them back. I kind of scribbled on them. I just wanted to say I look forward to working with you as we approach some kind of a legislative response to try to take some of the corruption out of this industry because I think that, personalities notwithstanding, the corruption is inherent in the system. This system does prey on poor people and puts a tax on poor people that is an illegitimate tax and one that I think we have a moral obligation to repeal. Thank you. The CHAIRMAN. Let me thank this panel of witnesses. You have been very patient and you have been very helpful to the committee. We have got other witnesses that we must hear. Let me excuse this panel. Mr. HAMILL. Mr. Chairman, one final point. The CHAIRMAN. If it's very important. Mr. HAMILL. Just on the practices of steering you were suggesting, I would just for the record indicate to you that Fleet has banks only in New England and New York and does not engage in the practices of steering that were being talked about. And I know you weren't directing it at us, but I want to make sure that's on the record. Thank you. The CHAIRMAN . Thank you . Let me thank this panel and excuse this panel. Let me now call our next witnesses to the table. These witnesses are, and I will call them in this order, Eva Davis, who is a resident of San Francisco, CA. Her home is in foreclosure following her receiving a second mortgage loan. Annie Diggs. Ms. Diggs is a resident of Augusta, GA. Like Ms. Davis, she has experienced problems after receiving a high rate second mortgage loan . Mr. Jack Long is an attorney with Dye, Tucker, Everitt, Wheale and Long of Augusta, GA. He is presently bringing a class action suit against Fleet in Georgia on behalf of second mortgage borrow- 291 ers, alleging reverse redlining and violations of the Georgia Fair Housing Act. Finally, Mr. Bruce Marks, who is the executive director of the Union Neighborhood Assistance Corporation in Boston. As executive director of UNAC, he has been a leading community activist involved in the second mortgage issue. Let me also say, as has been pointed out by Senator MoseleyBraun, in light of the President's State of the Union message tonight, we have been asked to attend a formal briefing on that issue here shortly. It will, in fact, start before long. What I want to do with this panel is for each panelist to give us their story and statement. After we have done that, we will take the time we have for questions. I am going to put the full statements in the record. In some respects , this panel is more important than the first panel . I am not going to hurry our way through this. We want to take the time we need. Ms. Davis and Ms. Diggs, particularly we appreciate your being here. Ms. Davis, we are going to start with you. We would like to hear your story now. STATEMENT OF EVA DAVIS, RESIDENT OF SAN FRANCISCO, CA Ms. DAVIS. My name is Eva Davis . I live in the Potrero district of San Francisco where I have lived for over 20 years . I am a widow and I live with my granddaughter and two grandchildren . In October of 1989, the great earthquake hit Northern California. It frightened me and the members of my family. It also caused minor damage to my home . But what happened after the earthquake to me and to my family and to my home was more devastating than the big earthquake. Nine months after the earthquake, two men came to my home. One visitor said he was a contractor. The other man said he worked for the Federal Emergency Agency, FEMA, where he said he processed loans for people like me whose homes had been damaged by the earthquake. The contractor told me that it would take about $6,000 to repair my front steps which had been damaged and tagged by the city of San Francisco as unsafe. It was this yellow tag stuck to the front of my home that had caught the eyes of the contractor as he drove by in July 1990 . I told the two men that I only had income of about $ 1,100 a month, that I could not pay for any repair to my home, and that I was not qualified for a loan because of my income level. At the time, I only owed $ 58,000 on my home and my home loan payment was only $619 a month. The only other debts that I had was about $700 to Montgomery Ward . I was current on that obligation. The two men told me that I could qualify for a Government loan and see if they could arrange a short time loan until I got the FEMA loan. They told me the Government loan would pay off the shelter loan and I would not have to pay the FEMA loan until I sold my home. They told me I could have other repairs done to my home under this program. This sounded pretty good to me, since I had not planned to sell my home in the immediate future. The contractor then called a person from the finance company in San Jose over 50 miles away. Within an hour, a loan officer ap- 292 peared at my home in San Francisco. By the end of the day, I was talked into a loan that they said would pay off my three existing loans and would permit me to make major repairs to my home. I wasn't told how much the loan would be for or any other details of the loan. In fact, since I suffer from glaucoma, I had recently broken my glasses. I wasn't able to read the loan papers or sign any documents. The loan officer just told me to sign my name on a blank sheet of paper and he would take care of everything. Within 2 weeks of meeting at my home, the loan contractor came to my home and told me that I had qualified for a loan of $ 150,000. I called Congress Mortgage and they told me that they had not paid off the first loan on my home as they had said they would. I learned that my monthly payment would increase from $619 to just under $2,000 a month. And I learned that Congress Mortgage was charging me $23,000 in loan fees. Within 5 months, my home was put into foreclosure by Congress Mortgage because I was unable to make the loan payments of nearly $ 2,000 with my income of under $ 1,100 a month. There was other problems as well. Congress Mortgage paid almost $ 700,000 to a contractor who quit work on my home and left my home in terrible condition. Over 2 years I have been fighting to save my home. I turned to Consumers Union for help and they found two attorneys who were willing to help me. They have told me that I may eventually lose my home , however they were able to stop the foreclosure sale of my home, which was supposed to take place at 10 o'clock this morning. I hope that members of Congress can do something to protect people like me whose only mistake was to trust people who sounded honest. My home needed less than $6,000 in repairs but I was talked into a $100,000 loan . Now I may lose my home. Please don't let this happen to anyone else. Thank you for letting me tell my story. Senator SARBANES. Ms. Davis, that's a very powerful and moving story and I want to go to Ms. Diggs. But I just want to be real clear on one thing. Before all of this started, you were paying $ 619 a month on the house payments? Ms. DAVIS. Yes. Senator SARBANES. You had an income of just under $1,100? Ms. DAVIS. Yes. Senator SARBANES. By the time they got through with you, you still had the same income, but you were now going to be required to pay just under $ 2,000 a month? Ms. DAVIS. Yes. Senator SARBANES. How could anyone expect you to pay $2,000 a month when you had an income of $ 1,100 a month? Ms. DAVIS. It's unbelievable to me. Senator SARBANES. Ms. Diggs. STATEMENT OF ANNIE DIGGS, RESIDENT OF AUGUSTA, GA Ms. DIGGS. My name is Annie Diggs. I have lived in the same house at 1522 Blakley Street in Augusta, GA, since 1936. On January 17, I celebrated my 78th birthday. I was born in 1915 in Macon, GA, and was raised in a community known as Shady Dale, GA. My father was born in the West Indies, but he drowned 6 293 months before I was born. My grandparents were born as slaves. My mother was forced to work for the fair, so she left me to be raised by a great aunt, who is my namesake, Annie Virginia Coleman. The Colemans were originally farmers in Georgia, but had to give up farming after the boll weevils invaded their farms. We moved to Athens , GA, where my great uncle worked for a company that made axe handles and hammer handles. When I was 14 years old, I married Will Diggs, who worked as a fireman for the Georgia railroad. The railroad moved us to Augusta in 1932. We moved into my present home in 1936. My husband and I was blessed to have 10 children, four of whom are still living. I became a widow in 1946. After my husband's death, I had numerous jobs , primarily of a domestic or clerical nature, such as a maid at University Hospital , a clerk at a grocery store, and I worked in a food processing plant known as Castleberry. For the last 27 years of my working life, I was employed as a domestic at Elliott's Funeral Home in Augusta. I stopped working at Elliott's in 1979. Since that time, my only source of income is my late husband's railroad retirement, which is now $515 a month. Additionally, I receive food stamps worth $60 per month . Frequently, I have to go without food. In 1987, my home needed major repairs, primarily due to a leaking roof. I went to a local bank. I had $343 balance on my existing mortgage. The local bank turned me down. Later, I was contacted by a woman working for a local loan company. She looked at my house and contacted a remodeling company that agreed to do the repairs for $3,300. She said she could arrange a loan. Also the manager of the loan company told me I should pay off several other little bills so I wouldn't have nothing to pay but my loan and so I could get some extra money to buy a washer and dryer too. They never told me the rate or how long the loan would last. When I went to sign the papers for my loan, I was asked to sign a stack of papers which I did not understand . Instead of the $3,300 which I originally needed , I ended up with a note to Tower Financial for $ 15,000 at an interest rate of 18.9 percent. My house is pledged as security. My monthly payments are $251.34 a month , almost half of my total monthly income. I was charged $ 2,595 or 212 percent of the loan in fees . My loan documents show that I received $4,328.48 at closing, but I didn't receive that. I don't know why they got me charged. I never had this money. I have never been told why I didn't receive the $ 1,900. Additionally, if I were somehow able to pay this loan off by refinancing, I would have to pay a repayment of $ 900, 6 percent of the original note. The home repair work was very poor, the paint peeled off, and my roof continued to leak. After one payment, I learned that my loan had been sold to Fleet Finance . I complained to Fleet about the sorry repair work. They said that was my problem. All they was interested in was getting the monthly payment on time. My ceiling finally fell in . For more than 5 years, I have lived in my house with the roof still leaking. All the while, I have paid 294 Fleet. I have paid more than $ 13,000 on my loan since 1987, but Fleet Finance tells me I still owe more than $16,000 on my loan. How can that be? I cannot understand how I could owe $ 16,000 on a loan that was originally only $ 15,000, especially after I have paid over $ 13,000 in monthly payments. I am scared of losing my home; I really am. I go to bed and get up in the morning looking for the mailman thinking I'm going to get a letter telling me to move. I finally got the repair work done right, but only after I got a grant from the City of Augusta Community Development Housing Rehabilitation Program . And I am thankful that you all give me this opportunity to come here today to tell my story. I am 78 years old. I ain't able to work. And every time I turn around, they badger me and badger me. I don't know. I just hope you all do something about this. They won't give you a chance. I didn't know Fleet. I never heard tell of Fleet until I got a letter. Then they're going to tell me I paid the first note to Tower. Fleet's going to tell me you've got to pay this note. We'll put it into your payment when you go to pay your last payment. You're going to pay this note because you were supposed to pay it to us. Senator SARBANES. We thank you very much for coming to tell that story. It is a very powerful story. Actually, Mr. Chairman, it underscores the point I was trying to make earlier. You have been foreclosed on your home? Ms. DIGGS. I am the lucky one. Senator SARBANES. But you have been paying and you have been paying dearly all these years. So we're told that, well, they lose money on the foreclosures but they're making money on your loan. Ms. DIGGS. If they take my home and sell it today, they can sell it for over what I got in here, $ 16,000 , $ 17,000. Because it looks like a new house. The stuff they tore out of my house was piled up high, all rotten lumber, the top of the house. Everything was rotten in there. I just wish I could have taken a picture and brought it to show you the beginning and how they fixed it. I am just happy. When I think the work it needed, my heart bled so bad that they're going to come and take it. Senator SARBANES. Mr. Long, we will be happy to hear from you. STATEMENT OF JOHN LONG, ESQ., OF DYE, TUCKER, EVERITT, WHEALE AND LONG Mr. LONG. Thank you very much , Senator. My name is Jack Long. I am an attorney from Augusta, GA. I am not here to criticize any one financial institution, but I am here to try to encourage change to correct abuses in home lending, which I , along with other lawyers in my area, see every day. We are not the traditional class action lawyers, because we represent a lot of traditional industries, insurance companies, and banks. However, we are morally outraged at what we have seen. Thirty years ago in the South, we had a system of dual waiting rooms , dual water fountains , and the like. Congress reacted . Today, our Nation is better. However, we still have a dual system of lending in this Nation in which whites, in connection with home mortgage loans, more often than not receive the benefit of market rate 295 home loans from traditional sources of financing. A substantial number of African-Americans only have one other source of lending on homes available; that is, loans at very high rates, very high prepayment penalties, very high points. The loans come from these non-bank banks that are completely unregulated by Congress . The sad thing about what I am telling you and members of the Congress is that these people are not on some Government program. They are not trying to get grants. These are Americans who work hard their entire lives to earn the American dream, their homes. Now we are faced with a situation in which they are losing these homes at astonishing rates. I noticed that previously we got a foreclosure statistic of 2.67 percent by Fleet. I don't want to criticize Fleet. I think that's probably for the finance company industry. That's way above the national foreclosure rate, which is one percent and less . You go back to 1980 with about half a percent or less. In 1991 according to the latest statistics , it was one percent. If you apply that statistic over a 15-year loan that we're talking about, 40 percent of these 20,000 loans are going to be lost in foreclosure . The examples of what I am about to describe to you are interest rates that make Master Card or Visa interest rates look reasonable. We all know that unsecured credit is the most risky credit. These loans I am about ready to describe to you are loans that have no relationship whatever to market rates . The first example I am going to give you is a loan entered into by Ms. Lucille Williams. This is not a Fleet loan. In fact, Resolution Trust Corporation owns it. This lady was charged 35 points ; $ 6,300 of an $ 18,000 loan, that was charged on the day the loan was made. The loan documents say that was a "bonus" or points. That is unconscionable, is unreasonable, and is mind boggling. Out of $ 18,000, she only received 65 percent at an 18 percent interest rate-a rate higher than a Master Card. The next example is the loan of Mr. and Mrs. Dukes. They were lucky! They were only charged points of 22.5 percent on a $ 16,200 loan at an interest rate of 18.5 percent. Both of these loans are secured by homes. Let's take Ms. Diggs's loan . And I submit to you, Senator, it is not the exception; it's the rule. Fortunately, we were given the privilege to ride to Washington in a bus with a substantial number of Fleet victims. We saw these same types of loans. People were handing them to us and saying, "look at my loan. " This is not the exception; it is the rule. In this loan, 20 percent of the loan with the points, plus an interest rate of 18.9 percent. They can talk about this lady's credit, but look at who she's paying off. She's paying off Macy's, she paid off her Visa card, she had good credit. Credit had nothing to do with it. They took advantage of an elderly black lady. She was denied credit from traditional sources because the Community Reinvestment Act is a joke. It doesn't work. Traditional banks do not lend in minority neighborhoods, thus they create a void . We talked about foreclosures . Mr. Willie Harris' loan is on a chart. We are handling a substantial number of Fleet loans . In 296 every one of their loans, we found they did a workup on foreclosure. We may not have all the records , but of the records we've seen, we see they make a profit. They have these people going both ways, Senator. Some of these prepayment penalties are up to 19 percent. So, you are charging points of, let's say, 20 to 25 points out in front. Then, on the date the loan is made, they're charging 18, 19 percent. They're charging a prepayment penalty of 19 percent. Customers are slaves to their loans. These companies make a profit if the customers pay, or if they default. They are lending at loan-to-value. Forget about income-to-value. They are lending at loan-to-value of 40 percent or so. That's such a big equity. The companies are going to make a profit even if they foreclose. I submit to you that what we see is wrong. As far as how to solve this problem, first of all, the Community Reinvestment Act needs to be strengthened. Banks are not lending in the minority neighborhoods. Congress needs to get tough just like you got tough with the South in the 1960's. We are better off as a people because of it. What you need to do is to stop all the mergers , stop the acquisitions, stop them from buying failed banks and making profits off of it, ifthey are not lending in the minority communities. Second of all , I think we need to have a nationwide cap. Now, in my part of the country, we talk of Government that is only supposed to defend the country and deliver the mail . We have to make exceptions to that philosophy when we see abuses . We need a cap , just like we have a minimum wage for income, you have to pay a certain minimum rate. We've got to stop these abuses . We are destroying entire neighborhoods in our section of the country. In fact, we all know that minority individuals in Georgia, even though they comprise about 27 percent of the population , only own 17 percent of the housing units. We found in our statistics and in our redlining cases and reverse redlining cases, that these loans are congregated. These high interest rates are congregated in the minority neighborhoods. The result is that owner-occupied houses become rentals. Neighborhoods are destroyed. The crime rate goes up. These social problems are created and the taxpayers have to pay. I'd like to end by saying this, Senator. The taxpayers had to spend billions of dollars bailing out the S&L's . I don't know of one savings bank or S&L that has gone broke from lending in the minority neighborhoods. They have gone broke because they lent money on some shopping center project, some condominium , vacation home, or something else . If they had complied with the Community Reinvestment Act in good faith, they probably wouldn't be in the position they're in today. I ask Congress to adopt legislation in two areas . One, we need to strengthen the Community Reinvestment Act ; and, two, put an interest rate cap nationwide on what these home equity lenders can charge. Thank you. The CHAIRMAN. Mr. Marks, we would be pleased to hear from you now . 297 STATEMENT OF BRUCE MARKS, EXECUTIVE, UNION NEIGHBORHOOD ASSISTANCE CORPORATION OF BOSTON, MA Mr. MARKS. Thank you very much. What we are here really for today, with all the people here, it is a wakeup call to Congress . It is a wakeup call . It is the real state of the union . The real state of the union is that there is a sub-tier financial system. It is not fringe. It is where working class people cannot get access to credit and therefore these creditors come in and steal their homes, milk them of their money and steal their homes. These are not people who are homeless. They are homeowners who are the foundations within our communities that no one has been paying attention to . And the state of the union is, we talk about drugs, we talk about violence, we talk about gangs, but these are the homeowners who are always the foundations, the stalwarts within their neighborhoods , who said to the craziness, the violence , and the gangs , stay out of my neighborhood. So what has happened is that's the problem. That foundation has been wiped out because they are subject to a sub-tier, not a fringe, a sub-tier financial system. But it is worse than that. It is because that's where the money's at. Fleet and some of the other corporations, ITT and Chrysler, but let's talk about Fleet because they have set the standard. They saw there was money to be made. They said this is a niche that we want to exploit. So what do you do? You want to reduce your risk and you want to maximize your profits. You reduce your risk by lending on people that have tremendous equity in their house, people that have been denied credit and have owned their homes for many, many years, often two or three generations. So what do they do? That's the community they want to target. People are desperate for credit because that's their major asset. They want to improve their major asset. So when someone comes knocking on the door and they say you're cash poor but you're property rich and we can put $20,000, $30,000, or $50,000 into your pocket, you tell me, Senator who would turn that down? When for generations you've been dying to have that opportunity. And when you have entities such as Fleet who has a national exposure saying, trust us , you can refinance. People are going to do that. It's not ignorance . It's what people do because that's what anybody would do. Let's talk about just how profitable this is. In 1991 , 55 percent of the income of the Fleet Bank Holding Company was made by Fleet Finance. Fleet could not have purchased the Bank of New England if it was not for Fleet Finance . The fact of the matter is, that was blood money. That was money made off the backs of working men and women whose homes they've stolen . Let's talk about just how that is. When you look at that map , that's the Federal Reserve , that area where you see the dots . Those are the areas where the Federal Reserve says, in Boston banks don't lend. Well, where those dots are are every mortgage that the resource companies financed by Fleet has made. 298 They're all within the minority community and now 82 percent of the people that purchased, that got a Fleet mortgage through the resource companies, have lost their homes. It's only a matter of time that when you have to pay up to 39 percent on a mortgage, you will lose your home. It's a matter of time because these are balloon mortgages with very high interest rates. The CHAIRMAN. Let me understand again what you just said. If I heard you right, you just said that within this zone that you've got on the map here, over some period of time, what percentage of the loans have now gone into default, and the people have lost their homes? Mr. MARKS. I'm saying, when you look at the default rate, and the people who have lost their homes through fraud, it's now become 82 percent. The number there is 76 percent. That was done about 7 months ago, and that's gone up. The CHAIRMAN. Again, I want to make sure we've got this straight for the record. You're saying that this cluster of people who had these second mortgages through mortgage companies of this kind, 70 to 80 percent of them actually ended up losing their residences. That's been the experience in Massachusetts? Mr. MARKS . Yes. The CHAIRMAN. Over what time period is that? What does that cover? Mr. MARKS. That will cover from 1985 to the period now. The CHAIRMAN. You're saying, in almost every case, it's a matter of people actually losing their property in the end. It's not a matter of just paying exorbitant rates and they paying it off. But in fact, it's like running on a treadmill and they pay the money, and then when the money runs out, they lose the property anyway. Mr. MARKS . That's right. Because if you look at the second mortgage industry, if it was legitimate, the high rates should only be for a period of time while people establish credit. So if you get a balloon mortgage payment that is in 3 years, in theory, you're supposed to be able to make those high payments for a short period of time, reestablish credit, and then you can refinance at a lower rate, which you are able to afford in not an unconscionable way. The fact of the matter is, that doesn't work. When you have a very high interest rate and you have a balloon mortgage, and you do not have access to refinancing of that, it's only a matter of time when you're going to lose your home. The CHAIRMAN. How many mortgages would that have been in the time period that you just said, from 1985 forward? Would that be 500 or a thousand? Mr. MARKS. We were talking, for this one company, which is called the Resource Companies . They have six different names but they are under one ownership. They were owned by a man named Burt Lambert. He was a college roommate of Terry Murray of Fleet. That one company made 330 mortgages within the Roxbury, Dorchester, Mattapan area within Boston . The CHAIRMAN. You're saying then the total over that period of time was around 300. Of that number, 70 to 80 percent were foreclosed on and people lost their homes. Am I following you right? Mr. MARKS . Yes . I just want to add one thing. 299 Within Massachusetts, you have what's called a soldiers and sailors foreclosure process . And it's one of the oldest ones on the books in the country. It stretches out the foreclosure process for at least 6 months . If someone is in the military, it's for 6 months that you cannot take their home. So what happens is, there's a deed in lieu of foreclosure. A lender goes and says, you haven't made your payments for 1 or 2 months. What we'll do is , if you sign over the deed , then we'll forgive that debt. Now, in Georgia what happens is that they have a non -judicial foreclosure. What happens is the lender just has to put the notice in the newspaper for 3 weeks, and on the first Tuesday of every month on the courthouse steps, they do the foreclosure. So you have two extremes. But Fleet gets around that one way or another. One way, they do the deed in lieu of foreclosure . On the other way, you will see foreclosures such as in Georgia. The CHAIRMAN. Why don't you go ahead and finish. Mr. MARKS. Sure. Fleet said that they make only 2 percent of their mortgages that are over 20 percent. But they're not really being straight, because the fact of the matter is they're saying the ones that are in their portfolio. The fact of the matter is, Fleet sells the majority of its mortgages. They are mortgage-backed securities . When you look at the SEC documents and you look at the prospectuses, you are talking about a far far greater number of the mortgages that are over 20 percent. We have the data, and we'd be glad to share the data with the committee here. The facts are when you look at the interest rates, and you look at these charts and look at those interest rates, you see interest rates of 24, 28 percent. You see them 30 and 40 percent. You see virtually no interest rates less than 20 percent. That's true on all of those mortgages. The CHAIRMAN. Let me be clear. You are asserting here today, that these loans are continuing to be made. Are you talking about loans out of the past, or loans that are still being made that would be well above the 20 percent, because they are sold off to somebody else. They don't show up on the portfolio, so that we would have to look at both categories to really understand what the history was. Is that what you're saying? Mr. MARKS. Right. What I'm saying is, the loans in the past , you've got to look at one, we're talking about the loans that were originated by brokers that were financed by Fleet. So don't take the whole portfolio. You've got to look at those predatory loans. We're not saying the loans that they made directly. When you look at the loans that were made by what we call the seven dwarfs, the seven mortgage companies that were controlled by Fleet, those loans , the vast majority of them were over 20 percent. Many of those, the vast majority of those were sold . So when Fleet says to you, of the loans we have in the portfolio, the fact of the matter is, they're not being straight. I think if this was a courtroom , the very proper recourse would be perjury. That's what's really going on. And if you look at what the first month of these mortgages are, the first month charges are, again , 15, 20, 30 300 percent. They're not telling you the truth. They are dealing with the technicalities on those issues . Let me go on to what we consider to be also a major issue. It's the safety and soundness issue. When you look at Fleet, and we've been in touch with the regulators for the last 18 months, we said, even if you're not going to consider the social impact of what Fleet does, consider the safety and soundness issue. You have approved Fleet's purchase of the Bank of New England because of Fleet Finance. But in reality, Fleet Finance is an albatross around Fleet's neck. So what is happening is, when we said to the Federal regulators, you have to scrutinize Fleet Finance, they knew nothing about it, because the Federal Reserve Bank does not regulate the finance companies or the bank holding companies. They have no basis on which to make an evaluation of it. So what is happening now is that we have requested the Federal Reserve Bank do an analysis of Fleet Finance, and to prevent Fleet from expanding or acquiring any more institutions before they really understand what's really going on with Fleet Finance. Because how can you make a determination of the safety and soundness issue when the most profitable entity you have is in the business of predatory lending? When the most profitable business you have is basically loan sharking? Because that's the reality. It's loan sharking. Anybody that charges 20 points up front over 30 percent interest rates and has the collection tactics that they have, I don't think there's another term for that. That's why we have a meeting at 4:30 this afternoon with the Board of Governors of the Federal Reserve Board. What we are requesting them to do is, we are requesting them to put a halt to any acquisitions of Fleet, so they cannot prey on any more people. There can be an effort to make a lot of these people here, who are Fleet victims, whole in the communities that they have devastated, to recompensate those communities. That's where we're at. But we have another request. That request is that there are many many people here who are here who came overnight who are going back this evening. We are requesting that this committee, that you hold regional hearings, that you go to other communities , that you go out there and you listen to what's going on within our communities, because when you thought, and you heard about the environmental activism of the 1980's, you have not seen anything yet. When you see the tens of thousands of homeowners who have been victimized by this type of predatory second lending around the country, who have always blamed themselves, who said it's my fault I lost my house. Who have taken that out on their families because there's no other recourse . There is a recourse now, and that anger and that frustration will be directed at the financial institutions who have preyed upon them . So what we request is that you start to hold those regional hearings so the thousands of people who couldn't come here , you can hear their stories, and you can get a better idea, because it is pervasive. It's the issue of the 1990's, and people are angry. 301 These issues need to be addressed. Thank you very much. The CHAIRMAN. Let me say to you very directly that we're starting down this track, not just with today's hearing, but with the other hearings that we've cited before today, the ones that have already taken place, and the ones that will be taking place, including the one next week, when the Federal Reserve comes in, and we take a look at these discriminatory lending patterns. I envision field hearings. So I appreciate the suggestion. I would also appreciate suggestions from you and others as to where those might be held, so we don't have to have people journey a long distance to come to Washington, although I appreciate the fact that so many have today. But, you know, to stay on that level of discussion for a moment, when we look around this country at why our urban centers and a lot of our rural centers are in such terrible difficulty, a large part of it is that proper flow of credit and community reinvestment has just been denied systematically over a long period of time. There have been other factors at work, but we are choking a lot of these communities to death by practices such as were illuminated today. I think the pillars of strength that are out there , either older people or other families that have had homes over the years and really provide the bedrock in a community, we're seeing these dynamics because of how badly the credit system is functioning, where practices spring up that actually destroy the rest of the strength that we have. You know, there has been, I think it's fair to say, a turning away from the problems of our inner cities and our lower income communities over the last several years. There was a big focus on foreign policy, everybody knows , particularly in the last 4 years, and not much attention being paid to problems in this country. That's changing. I think the President tonight will be talking about the sense of the State of the Union as he sees it. And part of that will be new strategies and new efforts and new resources directed at rebuilding our cities , and really turning our attention inward to try to figure out how we help our own country and our own people, which we haven't done very much of in recent years. In many ways, I think the neglect and the indifference , if not the actual practice of hostile policies , has damaged our country. It's damaged it in many ways. We've got two women sitting here right now who in effect have been damaged in the ways that they have described , but there are many others in this audience and many many more who can't be here today who, either through these problems and absence of credit, or an absence of credit on fair terms , because if somebody is creditworthy at 15 percent with 25 percentage points up front, they sure are creditworthy at a lower figure, especially if you've got a minuscule default rate, which is what we were hearing earlier. The basic economics actually turn right upside down . Because if that's the case, if we can make these loans at very high rates and people can meet them, then obviously they're going to have an easi- 302 er time of meeting them and your default rates will even be lower if the rates are lower. But our banking system, our insured banking system, has a responsibility here, and frankly it hasn't been met. It hasn't been met either in terms of an adequate community reinvestment effort, nor has it been done with respect to fairness to credit. The cold fact of the matter is, we've had patterns of discrimination in this country from the very beginning. Whether somebody tuned into the TV show last night, the Queen show that was on, talking about the problems facing black people over the history of this country, these discrimination problems are right here and now. They're pervasive and they're going on every single day in this country, and they're grinding down our people, and everybody suffers. When that happens, the whole country is lesser for it. It's not right, it's not decent, it's not what the country should be about, and it's not what our laws should tolerate. That's why we're here today to talk about this . This is just one part of the problem. The problem is much bigger than this. But we're meeting here not just to talk about it, we're meeting here to lay a foundation to do something about it. And in order, by the way, I might say, to do something about it, you need two things. You need the facts, and you need a good legislative proposal, you've got to then craft it and take it through the Congress, but you've got to have a President who will sign it. I think we've got both things in place now. We've got the ability to write a good legislative proposal, and to work it through the Congress, and I think we've got a President that will sign it, the sooner the better, in terms of the changes that need to be made. Ms. DIGGS. May I say something? The CHAIRMAN . Go ahead, Ms. Diggs. Ms. DIGGS. I have a neighbor. She's connected with Fleet, but she's got some children that were sick, and she couldn't come here to speak for herself today. Her name is Louise Darrian. She lives on my street. She's asked me to voice, she has a loan with Fleet. She's in the same boat as all of us here. They want to foreclose on her, but they haven't done it yet. We're the lucky ones, two of us in the same neighborhood. Her husband died , my husband died . She's with Fleet too. She's not working. I told her I would speak for her, as she couldn't come here today. The CHAIRMAN . Thank you . Does anyone want to say one other thing? Mr. MARKS. If I could just mention two things. One is we would request that you work with us in terms of the Federal Reserve Board in terms of having them take seriously the issue of Fleet and having them take seriously the issue of the expansion of Fleet. Second, we would suggest that when we talk about regional hearings, that you think about Atlanta, Charlotte, Jacksonville, as three of the places, because as Fleet's name in Massachusetts is synonymous with a loan shark, Fleet's name in Georgia is synonymous with a loan shark, soon Fleet's name in Florida will be synonymous with a loan shark. 303 We think that it's important that you come forward and that the committee deals in those areas, including North Carolina, to do that. If I can ask the people in the audience that came 16 hours, a lot of people to come up, they're going back this evening, if the people, so that you can get a sense. It's not me, it's not the people on the panel, it's all these people who have been victimized, who have either been foreclosed on, or are being pressured in terms of foreclosure to stand up. The people who all have a Fleet mortgage who came here today. These are the people who have come forward. They're just the tip of the iceberg. And many many wanted to come. We didn't have the buses to bring them. And there are many many that just couldn't come. Regional hearings we need that, please, to happen. The CHAIRMAN. Let me acknowledge everyone who stood. And let me invite you to go ahead and sit back down , having taken note of those who stood. This has been a very important hearing today, and this is not a courtroom and shouldn't be mistaken for one. I know there's a legal case pending. We can't try that case here and shouldn't try it here. And I don't want any misunderstanding on that issue. You made a comment earlier about your judgment that the earlier testimony you thought, in your mind, was a form of perjury. That's your opinion . I don't want to give any official blessing to that kind of characterization here, either way. I think it's important that those issues be settled where they are presently lodged, and that is in a court of law. Let me just make that plain. With respect to the issues involved here, though, in terms of the underlying problems facing the country, I think there is a need for a change in our practice and a change in our law. I think the States need to do more than they are now doing, because they have primary jurisdiction in this area, at least with respect to some of the practices we're talking about. I think there needs to be a Federal response here, and we're going to design such a response. I appreciate everybody that's testified here today. These are difficult issues and they are issues that are having a big impact on our country. I'd just say that if we're going to lift this country up again, if we're going to get our cities and our communities and our urban populations and our rural populations that are under pressure back on their feet, and getting stronger for themselves and their families, and for this country, we've got to change a number of things. We've heard about some of these things today that need to change. Getting this credit system to work, work properly, work fairly, work with fair prices, work in a fashion for all citizens of this country on an equal footing, is a critical need. We're not going to solve the problems any other way. We talk about the private enterprise system, but if it's only for some and not for all, it isn't going to work. So this committee intends to act on these matters. And I thank all of you for your appearance and statements today. The committee stands in recess. 304 [Whereupon, at 1:25 p.m. , Wednesday, February 17, 1993,the committee was adjourned , subject to the call of the Chair.] [ Prepared statements of witnesses and additional material supplied for the record follow:] 305 PREPARED STATEMENT OF SENATOR BEN NIGHTHORSE CAMPBELL Thank you Mr. Chairman, for holding this hearing today on home equity lending. I am very interested in hearing from the panels concerning reverse redlining and to learn more about what can be done to change this trend. As you know, reverse redlining occurs when second mortgage lenders victimize vulnerable homeowners by coaxing them into signing home equity or home improvement loans they cannot afford. Homeowners who have nowhere to go for credit because mainstream lenders are reluctant to lend to low-income families are targeted by second mortgage lenders and charged very high interest rates on loans. If this is taking place in the lending industry, which we are here to learn more about today, we need to take steps to do something to stop this unfair practice. I have always been concerned about the disadvantaged and minority individuals in poor communities, especially in rural communities and on Indian reservations, and am very interested to hear what suggestions you have and what steps you think we should take to protect the disadvantaged in our society. I look forward to hearing testimony from the consumer and housing groups, the Office of the Attorney General, the residents, the banks and community activists. PREPARED STATEMENT OF SENATOR PETE V. DOMENICI I am pleased we are having this series of hearings on the access to capital in lowincome and distressed communities. The practice of reverse redlining, that is to say targeting low income or minority communities for credit at exorbitant rates and unscrupulous terms is certainly something this committee should be concerned about New Mexico is a state with a large Hispanic population . Thirty percent is Hispanic, another 10 percent is Indian. This is an issue that is very important to me. A staff member of mine's mother was almost the victim of one of these home improvement scams. She is a widow, an immigrant to this country. She lives alone and she was so frightened when these people came door to door trying to sell home improvements at an inflated price, on very severe credit terms. She was afraid at first to go to the police. She was afraid the workmen would revisit her and beat her up. I found the materials on this issue very interesting. I question whether our tax laws, in allowing a deduction for home equity loans are partially at fault. Prior to 1986, there were very few of these open ended home equity lines. Since the 1986 tax law, these types of loans have sky-rocketed. It also appears that the Community Reinvestment Act may also be contributing to the problem since it does not distinguish between loans actually made by the financial institution and loans purchased by the financial institution . We can address the tax law and the CRA shortcomings, but perhaps the greatest service can be done by investigative reporters who can widely publicize these scams. We need to better educate homeowners to these very sophisticated schemes and what the ramifications really are. The best program for low-income borrowers is to have a vibrant economy. We want the recession to end, but we can't get from here to there without a strong real estate market. While most people are focused on tonight's speech by the President, much can be done to help home buyers and the housing industry through the Banking Committee. Nothing in our national experience captures the American dream more than home ownership. All Americans need to be part of this dream. While bankers for years have denied that mortgage discrimination exists, the recent Federal Reserve data proves that mortgage discrimination exists . The decline in real estate values has sharply reduced the net worth of many American families since two-thirds of all American families' wealth is in the form of real estate. Reviewing these statistics, it is easy to understand that the decline in real estate values has contributed to consumers' lost confidence . Federal Housing Administration (FHA) I have a proposal to expand home ownership through the Federal Housing Administration (FHA) by helping first-time, low-income, and minority borrowers. Since FHA is a 100 percent federal guarantee, it should be better targeted to those who are denied mortgage credit and provide a back up reassurance to reluctant lenders. The fundamental impediment for first-time home buyers is the downpayment. Most private sector mortgages want at least 20 percent in a downpayment or pri- 306 vate mortgage insurance. However, FHA borrowers can put up as little as 3 percent in a downpayment. This bill requires FHA to develop new programs to improve its ability to better serve low-income, minority, and first-time home buyers. HUD will be required to report to Congress within one year on how it plans to implement new programs. According to Census Bureau data, nearly 85 percent of all first-time home buyers are white, while 10 percent are black and 5 percent are other minorities . Nearly 90 percent of all homeowners are white. According to Federal Reserve data, only about 15 percent of FHA's portfolio is serving low-income borrowers. An FHA guarantee is obtained based on home purchase price, not income of the home buyer. FHA needs to better target its resources to low-income borrowers and provide government guarantees to those who are being denied mortgage credit. This bill stimulates the housing market by increasing the FHA mortgage amount of $125,000 for first-time home buyers in high cost areas. Nearly 33 percent of all first-time home buyers take advantage of a federal guarantee to obtain a mortgage. This bill allows borrowers in high-cost areas to take advantage of the FHA government guarantee . Nothing in this bill changes the intent or the need for the FHA reforms. The reforms were needed to guarantee the fund operates in a financially sound manner. FHA can target the federal guarantee without threatening safety and soundness. PREPARED STATEMENT OF SENATOR CAROL MOSELEY-BRAUN I wish I could say I am pleased to be here this morning, Mr. Chairman, but I am sorry to have to be looking at lending practices that take unfair advantage of low-income American homeowners. Home ownership is at the core of the American dream, and achieving home ownership is particularly tough for low-income Americans. Lending practices that prey on the vulnerabilities of low-income homeowners, therefore, are particularly troubling. "Reverse Redlining" is a new term. It refers to lending practices that involve charging very high rates of interest and equally high up-front loan origination fees to borrowers that really cannot afford the loans. The results of "Reverse Redlining" range from less money for the basics like food, heat, and electricity for the low-income borrowers, to ever-increasing debt loads, to outright loss of the low-income borrower's most precious possession- his or her home. We have recently held hearings in this committee on how to get more money into low- and moderate-income communities through a community banking initiative and by strengthening the Community Reinvestment Act. Today's hearing demonstrates clearly why those objectives must be priorities for the committee this year. It is clear that we have to act to address the "Reverse Redlining" problem. I do not want to suggest, however, that mortgage brokerage and finance company activity is in and of itself a problem, or and purchases of loans by one financial institution from another, are not in most cases appropriate. Mortgage brokers and finance companies fill a real need in our finance system, and in the great majority of cases, loan purchases are entirely legitimate. And I do not want to suggest that mainstream financial institutions are engaging in behavior that hurts low-income homeowners as a standard business practice . I am sure that virtually every mainstream financial institution in this country joins me in condemning fraudulent lending practices . What I hope we will focus on, therefore, is what should be done. What I want to know is how can we improve our laws and our law enforcement so that we can put an end to "Reverse Redlining." I congratulate you for calling this hearing, Mr. Chairman, and I look forward to working with you, with my colleagues on the committee, with our witnesses this morning, and with all interested parties in an effort to answer the legal and enforcement questions and take the actions necessary to solve this problem. 307 SCOTT HARSHBARGER, ATTORNEY GENERAL COMMONWEALTH OF MASSACHUSETTS A SPECIAL REPORT ON THE ATTORNEY GENERAL'S RESPONSE TO THE HOME IMPROVEMENT AND MORTGAGE SCAMS IN MASSACHUSETTS : ENFORCEMENT, LEGISLATION AND REGULATION OCTOBER 30, 1992 A LETTER FROM THE ATTORNEY GENERAL To Whom It May Concern: During the last 18 months, my office has undertaken a comprehensive program of enforcement, and regulatory and legislative action to address the consumer harm resulting from unscrupulous lenders and home improvement mortgage contractors. Investigations by my office showed that vulnerable homeowners many of them elderly, minority and inner-city residents- were targeted by certain brokers, lenders and contractors, to take out second mortgages with unconscionable terms and conditions. The most decisive factor for these lenders was whether the consumer had sufficient equity in his or her home to cover the loan in case of default. In many cases, irresponsible lenders gave scant attention to whether consumers could repay their loans with their monthly income. As a result, these consumers were laden with unmanageable debt and, in numerous cases, lost their homes through foreclosures. Following complaints received by my office, I mobilized a Home Improvement and Mortgage Task Force to take swift action on a variety of fronts to end this insidious form of urban economic violence, in this case blatant victimization of vulnerable homeowners . This report describes the origins of the second mortgage lending scams, the nature of the illegal activities that took place, the actions my office took to remedy those problems and, most importantly, how to prevent these scandals from happening again. Some ofthe major highlights, finding and recommendations of the Task Force are: • The Home Improvement and Mortgage Task Force has initiated 13 enforcement actions in the last year. These actions have already produced more than $40 million in legally enforceable benefits to Massachusetts consumers, particularly consumers of low and moderate income. More than 1,000 families will be assisted by settlements already reached. • Unprecedented and creative regulations have been promulgated to curb future abuses, and new mortgage licensing and home improvement laws have been enacted to legislate positive change. • The widespread home improvement and mortgage scams apparently are primarily the by-product of greed and of the failure of numerous Massachusetts institutions. • Large financial institutions failed to police their own industry; community organizations and educational institutions and agencies failed to regulate adequately abuse by home improvement contractors and lenders. • Greater community access to the services of respected financial institutions is required. • More diligent monitoring of financial abuses must be a priority for the mainstream financial institutions and for regulatory agencies. • Extensive educational efforts to advance consumer understanding of financial transactions are also required. I am proud of the success of the Task Force, which consisted of attorneys, investigators and support staff, whose commitment, skill and dedication made this all possible. The Task Force enforcement actions will provide relief for thousands of victims and hopefully prevent the tragedies which occurred from being repeated in the future. I welcome your comments and suggestions on this report and important issue. It is only through working together in partnership that we will be able to protect those in society who need it the most and prevent victimization before it occurs. Sincerely, Scott Harshbarger 308 I. INTRODUCTION In recent years, across cities and towns in Massachusetts, a familiar sequence of events took place: inner-city and suburban homeowners, who were income poor, but had considerable equity in their homes, were targeted to enter into high interest rate mortgage loan transactions, often with unconscionable terms and conditions attached. The irresponsible lenders who preyed on these vulnerable consumers were interested primarily in the equity that these homeowners had built up in their homes, rather than whether consumers could repay the loans with their monthly income. In hundreds of cases, when consumers could no longer repay these second mortgages, lenders foreclosed on the family home and entire families were evicted. As homeowners are foreclosed upon, the social fabric of a community is torn apart and the community is destabilized. Destabilized communities are breeding grounds for further forms of economic and other types of urban violence. Over the past 18 months, the Office of the Attorney General has been investigating and prosecuting unscrupulous lenders, brokers and contractors who engaged in home improvement or second mortgage schemes in an effort to steal the homes of consumers . This work has been largely undertaken by the Home Improvement and Mortgage Task Force which Attorney General Harshbarger created in July, 1991, by drawing upon the resources of numerous divisions within his office. Prior to taking any formal legal action, the Task Force issued dozens of subpoenas, interviewed hundreds of consumers and sought the advice of various banking and lending industry experts. The actions that were eventually taken by the Task Force were based on a careful assessment of the facts and the law that was part of the exhaustive investigation. This report is intended to alert individuals, homeowners, community organizations, regulatory and law enforcement agencies and our major financial institutions to the various scams that the Office of the Attorney General investigated and brought to light and that can be so destructive to families and whole communities. II. BACKGROUND-SETTING FOR THE PROBLEM During the 1980's, the Massachusetts real estate market experienced unprecedented growth. Property values skyrocketed, and individuals who had purchased properties in the 1960's and 1970's saw the equity in their property increase dramatically. During this period, scams emerged that were designed to persuade homeowners to transfer the built-up equity in their homes to lenders, brokers and home improvement salesmen under loan conditions that contained unconscionable terms, or under promises of home improvement repairs that were overpriced, faulty or never took place. Those hardest hit by these scams were the elderly, those already in financial distress, those unsophisticated in financial transactions, communities of color and others, who while income poor or on fixed incomes, had built-up significant equity in their homes. These schemes flourished for a number of reasons. First, it appears that the only credit available to these consumers was from the then unregulated and unlicensed second mortgage companies and brokers. These lenders and brokers were not able to police themselves sufficiently to prevent economic exploitation by a certain few. This exploitation was aided by unethical brokers who extracted large, unconscionable fees from consumers and who, in some instances, had undisclosed financial and corporate ties to lenders whose primary goal apparently was the acquisition of real estate . Second, the simple fact is that many inner-city communities across this state were abandoned by mainstream lending institutions during the 1970's and 1980's. Even during the economic boom years of the 1980's, little attention was paid to capturing inner-city markets, and creating loan products or providing access to banking services to these communities. Given the void of credit options created by mainstream financial institutions, the unscrupulous contractor and high rate lender entered the picture and marketed their products to vulnerable homeowners. While there was a lack of access to traditional credit products for these consumers, mainstream financial institutions were funding high rate second mortgage lenders and unscrupulous contractors who were selling loans to these communities. Thus, in addition to the law enforcement attack directed toward specific second mortgage lenders and brokers, the Task Force also took a hard look at those mainstream financial institutions that provided lines of credit to or purchased mortgages from unscrupulous second mortgage lenders. 309 III. ALLEGATIONS APPARENT SCOPE OF PROBLEM The Task Force uncovered wide-ranging allegations of wrongdoing falling into the categories listed below. Consumers, community organizations and law enforcement agencies should familiarize themselves with the listed scams and be on guard for them in their individual communities. A. Misrepresenting the Nature of the Transaction • Informing consumers that they are mortgaging their homes when they actually are deeding them away and merely retaining a right to repurchase the home; • Misrepresenting the home improvement work to be performed, the price to be paid, the interest rate, the amount of the loan, the monthly payment or other term ofthe loan; and • Misrepresenting that a broker is a lender when, in fact, the broker is merely arranging the loan for a fee rather than actually making the loan. B. Illusory Inducements • Promises by a home improvement contractor or lender that he will give the consumer a job to help pay off the loan; • Promises that onerous loan terms will be rewritten in the future, if the consumer just agrees to pay those terms for a brief period; • Charging a cash fee in return for a promise to find immediate refinancing for a consumer already facing imminent foreclosure when, in fact, nothing is done for the consumer other than taking the fee; and • Giving consumers lump sum cash payments "to use as they see fit" as part of mortgage loan proceeds disbursements in order to induce consumers to agree to unaffordable loans. C. Pressure and Coercive Tactics • Consumers are rushed through the loan documents without an adequate time to read and understand them; Consumers are told that no lawyer is needed to assist them; Consumers are told that the contractor cannot get funds to begin home improvements until the bank releases funds and that the bank will not release such funds until the consumer signs a completion certificate indicating work is complete even though work has not even begun; and The consumer's ability to read loan documents is physically obstructed by the arms of the contractor across loan documents or because loan documents are rolled up, only revealing signature lines. D. Failure to Disclose Key Elements of Transaction • Asking consumers to sign incomplete documents missing such key elements as the interest rate, the finance charges and the number of payments; • Failure to disclose that a mortgage is being taken on the consumer's property to secure the loan; and • Failing to disclose that a consumer has inadequate income to repay the loan and that default is therefore likely. E. Forgeries and Falsification • Forging a consumer's signature to the certificate of completion credit application or other loan document; and • Falsifying a consumer's income, by use of false or forged tax statements and rent receipts, in order to inflate the consumer's income and thereby arranging loans the consumer cannot afford. F. Unconscionable or Unaffordable Loan Terms • Balloon payment requiring consumers to make large payments of principal usually within a year or two of the loan closing; • Excessively high loan fees, including broker fees, origination fees and late payment fees; • Escrow and security fund accounts on which the consumer is charged interest but from which the consumer derives no tangible benefit; and Excessively high interest rates. IV. ACTIONS BY THE TASK FORCE Attorney General Harshbarger charged the Task Force with initiating a multipronged attack on the scams. This included initiating litigation, drafting and supporting legislation, and promulgating regulations. 310 A. Litigation The Task Force has initiated 13 actions relating to home improvement and mortgage scams in approximately the last year. These include actions targeting banks, mortgage companies, home improvement companies and individual home improvement salesmen and mortgage company executives. The actions include the following: 1. Bank Settlements The Task Force has entered into six separate settlement agreements with Boston area banks. These agreements were entered into following receipt by the banks of letters from the Attorney General indicating an intention to file suit, if settlements could not be reached. We were pleased that the banks involved, once they were aware of our commitment to seek effective remedies, chose to negotiate and settle their respective cases, rather than invest the cost and time involved in litigation. The bank settlements include: a. BAYBANK SETTLEMENT In February, 1992, the Attorney General reached agreement with BayBank regarding any liability it may have had in indirectly financing home improvement transactions. Under the terms ofthe settlement, BayBank agreed to establish a program to resolve consumer complaints regarding home improvements that BayBank financed indirectly through contractors between November, 1987 and February, 1992. BayBank, in effect, agreed to accept responsibility for any improper conduct by home improvement contractors where BayBank has indirectly financed the work. As part of the settlement, BayBank also agreed to make $5 million in below-market rate home improvement financing available to low income communities and $6 million available for the construction of affordable housing. The Lawyers' Committee for Civil Rights and the NAACP Legal Defense Fund, Inc. also assisted in the case and participated in the settlement. b. SHAWMUT BANK SETTLEMENT Attorney General Harshbarger reached a $7 million settlement with Shawmut Bank to resolve the Task Force investigation of Shawmut Bank's role in funding Resource Financial, a second mortgage company sued by the Attorney General . The settlement requires Shawmut to make $5 million in mortgage loans available to low income communities. These loans will have the following extraordinary features: (a) no downpayment required; (b) no closing costs; (c) an interest rate one point below Shawmut's regular rate. The settlement further requires Shawmut to make $2 million in below-market rate home improvement loans available in targeted low income communities. In addition, the agreement requires Shawmut to provide either a new loan or an average of $6,000 in cash to approximately 50 specific Resource borrowers whose loans were funded by Shawmut. The Union Neighborhood Assistance Corporation provided the Task Force with information regarding certain Resource borrowers who are aided by the settlement and others described below. C. FLEET BANK SETTLEMENT The Attorney General, in April of this year, reached a settlement with Fleet Bank to resolve its role in funding Resource Financial Group. This settlement requires Fleet to establish a $ 12 million mortgage program for low income communities. The program will have the same extraordinary features as in the Shawmut settlement. In addition, Fleet agreed to provide new loans or a $6,000 cash payment to each ofthe approximately 40 Resource borrowers whose loans were funded by Fleet. d. QUINCY SAVINGS BANK A settlement also was reached with Quincy Savings Bank to resolve claims against Lincoln Trust Company, which merged into Quincy Savings in early 1992 and which also had funded Resource Financial Group. Quincy Savings Bank agreed to provide either a new loan, on very favorable terms, or a $ 1,250 cash payment to 100 Resource borrowers. As part of the agreement, Quincy Savings also agreed to make $3 million in mortgage money available, again on terms extraordinarily favorable to consumers . e. SOUTH SHORE BANK In June, 1992, the Attorney General settled mortgage related claims with South Shore Bank, which also funded Resource Financial Group. South Shore agreed to provide relief to 367 Resource borrowers. Of this total, 278 Resource borrowers who have already paid off their Resource loans will receive a flat cash payment of $2,350. An additional 68 Resource borrowers whose loans are still outstanding will receive either the cash or a refinancing of their loan on very favorable terms. The remaining 21 Resource borrowers whose properties are currently held by Resource 311 will either receive cash or a loan: to reacquire their homes. Finally, the agreement requires South Shore to donate $ 150,000 in cash to establish a legal assistance program for consumers facing foreclosure by lenders other than Resource. f. USTRUST SETTLEMENT A sixth and final bank settlement was reached with USTrust to resolve claims regarding its role in indirectly financing home improvement transactions. USTrust agreed to establish an arbitration program for any consumer who has a complaint regarding home improvement loans funded by USTrust. Under the program, a consumer with a valid complaint can obtain up to $ 1,000 for Truth-in-Lending violations, can have his or her home improvement loans rewritten on favorable terms and can have shoddy home improvement work repaired at no cost, among other types of relief. Several hundred consumers could qualify for the arbitration program. ÚSTrust also agreed to provide a $3 million mortgage program targeting low income communities. Finally, USTrust agreed to make $2 million in below-market rate loans available to minority owned businesses. 2. Mortgage Company Litigation The Task Force also has initiated litigation directly against a number of mortgage lenders including Seacoast Industries, Resource Financial Group, Inc., the Money Tree, Inc., Rhodes Financial, Inc., and State Finance and Mortgage Company of Springfield. Each of these cases is in litigation, although several defendants have announced that they are going out of business in response to the suits. 3. Home Improvement Company Litigation The Attorney General also has sued a number of home improvement companies, including Seacoast and Carefree Building Products, Pro-Tec-To Rolling Shutters of New England, Inc., and Rolling Shutter Systems of New England, Inc. These suits are pending. 4. Home Improvement Salesmen The Attorney General also has initiated two separate consumer protection actions against four former salesmen for Vinyl Distributors of New England. B. New Consumer Protection Regulations In addition to litigation that will provide relief to consumers for past injuries, the Office of the Attorney General promulgated a comprehensive set of consumer protection regulations that are intended to create a level playing field for all lenders and to protect consumers from future abuses by unscrupulous lenders and brokers. The key features of these unprecedented regulations, which were promulgated following public hearings, include: • Requiring that all brokers and many lenders provide borrowers with standardized copies of the Attorney General's Mortgage Broker and Lender Disclosure Forms. These forms identify in simple and clear language the essential features of a mortgage loan transaction as well as the cost and interest rate the borrower will have to pay; • Requiring that lenders and brokers take reasonable steps to assure that borrowers understand the loan transaction. This is an effort to address the needs of nonEnglish speaking borrowers. The regulations recommend the use of adult interpreters or translated disclosure forms, which will be provided by the Attorney General's office in several languages. • Prohibiting unconscionable rates or other loan terms. As an example of unconscionability, the regulations indicate that factors to be considered include whether an interest rate is 10 percent above the Wall Street prime rate, or 20 percent. • Prohibiting the advertisement of various inducements such as use of the words "immediate approval" of loan applications or "immediate closings;" the regulations also prohibit the advertisement of a "no points" mortgage loan when that is not the case. • Severely restricting the use of certain other inducements such as "bad credit no problem" and "avoid foreclosure." Lenders and brokers cannot use these terms in advertisements unless they fully disclose all the restrictions that may apply to such loans. In addition, brokers and lenders who use such inducements must provide the following warning: "You may lose your home if you cannot make all of the payments or if you miss any of the payments on this loan." A number of organizations assisted in the development of these regulations, including the Massachusetts Bankers Association and the Massachusetts Association ofMortgage Lenders and Brokers. 312 C. Legislation to Regulate Home Improvement Contractors The Attorney General played a major role in working with the Legislature to secure passage of the new law regulating home improvement contractors. The law enacted includes several important provisions which will: • Prohibit home improvement contractors from also acting as mortgage brokers or lenders in connection with the home improvement contracts they enter into; • Require contractors to register with the Commonwealth's Bureau of Building Regulations and Standards; • Require a written contract between a contractor and a homeowner for any job over $1,000, detailing the work that needs to be completed and the terms of the agreement; • Establish a Guaranty Fund to provide limited restitution to consumers who have been defrauded by a registered contractor but are unable to collect on the judgment; and • Provide for criminal penalties for home improvement contractors who fail to obtain a certificate of registration. D. Foreclosure Assistance In response to the widespread incidence of foreclosures related to home improvement and mortgage schemes, the Attorney General, in June, 1991 called for and received extensive cooperation from over 100 lenders in a voluntary 120-day moratorium on foreclosures . After initiating this voluntary moratorium, the Attorney General's office supported the passage of a mandatory moratorium which was enacted by the Legislature. The Attorney General's office worked with private bar counsel and Registers across the state to enforce the moratorium. In addition, the Task Force provided emergency assistance to individuals facing immediate foreclosure. As a result of this assistance, hundreds of foreclosures were delayed or cancelled. In those instances where it was not possible to stop a foreclosure, consumers were referred to appropriate social service agencies for assistance. VI. CONCLUSIONS AND RECOMMENDATIONS As a result of its 18 months of work in the home improvement and second mortgage arena, the Task Force has reached the following conclusions and makes the following recommendations: A. Conclusions: • The unregulated and unlicensed mortgage broker and lender industry was unable to police itself to restrain adequately unscrupulous lenders and brokers from unfair and deceptive practices in the provision of second mortgage lending services. • Entire communities abandoned by mainstream financial institutions are attractive prey to high pressure and illegal tactics by unscrupulous lenders and brokers in the provision of second mortgage products. • Vulnerable and unsophisticated consumers need to be educated to the dangers of urban economic violence that can accompany equity-based financing. B. Recommendations: • Lending associations should establish rules of conduct and codes of ethics for members and discipline those who breach such rules and codes. • Consumers in low income neighborhoods need greater access to more branches in low income communities. Financial institutions need to create innovative credit products for these communities, and must aggressively market these and traditional products to low income consumers. • In fulfilling their Community Reinvestment Act responsibilities, mainstream banks should actively reach out to low and moderate income, minority and nonEnglish speaking consumers. There is a compelling need for banks to become more "user friendly" to low and moderate income communities all across Massachusetts. • In particular, banks should develop mortgage loan programs that are maintained in their portfolios so that more liberal and more flexible lending criteria can be applied to low and moderate income applicants. Mainstream financial institutions should expand second mortgage and equity based lending programs, with appropriate safeguards, so that more such lending can be made available to low and moderate income consumers. • Banks should formulate long-range plans to include branches, loan production centers and automated teller machines in low and moderate income neighborhoods. Access to banking services is an essential part of modern life, and it is as necessary as telephone, gas or electric utility services. 313 • Mainstream banks should examine and scrutinize their financial relationships to other lenders that provide credit in low and moderate income and minority neighborhoods. Banks must look at the impact of the mortgage companies they finance on affordable housing and gentrification. Financial institutions must make sure that the mortgage companies which they finance are lending on terms that are fair and that such terms are not unconscionable. Mainstream banks must avoid financing high-rate equity-based lenders. • Second-mortgage lenders' and brokers' associations should aggressively police themselves consistent with the Attorney General's consumer protection regulations and with the Commissioner of Banks licensing regulations. • Public schools and community organizations must expand consumer education programs so that consumers fully understand the fundamental terms of basic financial transactions. At a minimum, each graduating student should understand the concept of interest and credit, and the basic elements of a mortgage transaction. • Public institutions and agencies need to monitor newly-adopted regulations to insure that they are effective in curbing past home improvement and mortgage abuses. They likewise need to enforce aggressively compliance with the new mortgage licensing and home improvement statutes. The problems that created the second mortgage scandals are complex and cannot be eradicated overnight. However, the recommendations outlined in this report, if adopted and carried out by mainstream banks, second mortgage lenders, brokers, communities and public agencies, are a necessary first step to changing the urban economic landscape from one of deprivation and disintegration to one of hope and opportunity. The equity-based lending that was carried out under unconscionable terms and conditions by irresponsible businesses is just one form of urban economic violence that we must seek to prevent. But, only by aggressive vigilance, and the availability and access to products to meet the needs of the consumers who were targeted can the remedial process begin. And it is the responsibility of all of us. TESTIMONY OF THE NATIONAL CONSUMER LAW CENTER (KATHLEEN KEEST, ROBERT HOBBS, MARGOT SAUNDERS, GARY KLEIN) PREDATORY HOME EQUITY LENDING FEBRUARY 17, 1993 PROBLEMS IN THE HOME EQUITY MARKET: PREDATORY LENDING¹ Mr. Chairman and Members of the Committee, thank you for your invitation to testify today. The National Consumer Law Center is an organization which acts in part as a national support center for legal services attorneys and pro bond attorneys representing low income consumers around the country. These attorneys routinely request us to help analyze credit transactions and determine what legal rights and remedies their clients might have. As a consequence, we have seen examples of predatory home equity loans from all over the country-the kind of lending which can devastate its victims. Today you will hear from several other witnesses who can give you some vivid, real-life examples of overreaching lending practices which have contributed to record high foreclosure rates and the heartwrenching loss of homes to the auction block throughout the country. Rather than add to that litany, we will focus on what we believe has contributed to the increased incidence of predatory lending during the past decade, and on what reforms we believe may help curb the excesses.2 ¹This statement may use the more common term "second mortgage" to refer to what are more precisely called "home equity" loans; that is, non-purchase money loans secured by residential real estate, irrespective of the priority of the lien. Some examples of the kinds of outrageous practices we have seen may be found in NCLC publications, such as: Hobbs, Keest, DeWaal, " Consumer Problems with Home Equity Scams, Second Mortgages, and Home Equity Lines of Credit," (AARP 1989) [hereafter "Consumer Problems"]; Keest, "Second Mortgage Lending: Abuses and Regulation," (NCLC, for Rockefeller Family Fund, 1991 ) (hereafter "Abuses and Regulation"]; "Nature Abhors a Vacuum: High-rate Lending in Redlined, Minority Neighborhoods in Boston," and "Principal Padding. The Prepaid Payment Pyramid," 9 NCLC REPORTS Consumer Credit & Usury Ed. (May/June 1991 ). 314 THE CAUSES Though home equity lending abuses are not new, the 1980s witnessed a major upswing. "Equity-skimming," or "equity-theft" became a major threat to many homeowners in particular to the most vulnerable. A number of factors converged to contribute to the problem: Deregulation: In tandem with the appreciation of real estate values, (see below), the deregulation of consumer lending in the 1980s left the door wide open for unscrupulous operators. Congress' contribution was to preempt both state usury ceilings on mortgage lending secured by first liens (whether purchase money or not),5 as well as state limitations on risky "creative financing" options, such as negatively amortizing loans. Federal deregulation also set the stage for many states to remove rate caps and other limitations on other lending- including second mortgage lending. Whatever the overall merits of economic deregulation, it undeniably unleashed the greedy instincts of unscrupulous operators all over the country. In keeping with the conventional wisdom of free market theory, "the market" was supposed to take care of any problems. Unfortunately, there are market failures, and predatory home equity lending provides a good example of one. Even as the cost of funds has declined, these lenders have not lowered their rates, and for a number of reasons, competition and market forces don't operate according to theory in these loans.7 The Rise in Real Estate Values: The inflation in real estate values in the 1980s created much new wealth-the equity pool. Since real estate secured lending-particularly owner-occupied residential real estate-has historically been among the safest kind of lending, creditors of all stripes strove to develop or increase their portfolio of real-estate secured loans. Legitimate lenders simply sought increasingly secure loans. The marginal lenders-the equity skimmers- looked to this new equity pool as something to enrich them. In turn, the appreciated value of the property led to "asset-based lending"-that is, loans made based on the value ofthe security, rather than on the borrower's ability to repay. This has been common in commercial lending, but is unsuitable for consumer loans in a humane society. Most borrowers are simply wage-earners who look to their regular income to repay their debts. The amount of equity in the collateral is only relevant to the ability to repay a loan if the borrower intends to liquidate the collateral . In short, " asset-based lending" is a legitimate-sounding justification to ignore sound underwriting principles, and make unaffordable loans . Equity skimmers may write loans with repayment terms which borrowers could not hope to meet over the long haul: monthly payments which are 70 percent or more of monthly income (or, in one case we've seen, monthly payments more than monthly income ); or large balloon payments which the borrower has no realistic hope of making. The loans are made because the lender can't lose: either they will be repaid at a high interest rate, or, too often, through the foreclosure process . 10 The Rise in the Secondary Mortgage Market: Some high-rate mortgage lenders, particularly home improvement contractors, have historically operated by assigning installment contracts they write to other lenders, such as finance companies or banks. But the 1980s added a new wrinkle-bundling mortgage loans into large portfolios and selling them on the secondary mortgage market. This enabled mortgage companies specializing in home equity lending-unregulated in many statesto operate. Since there was a "back-end" income stream, they could operate with litIn fact, during the last cycle when serious abuses in this industry attracted public outcry and led to regulatory reforms , Congress created the Truth in Lending rescission right, 15 USC § 1635, now one of the most valuable tools available to attorneys representing second mortgage scam victims. See p. 5, infra. "Depository Institutions Deregulation and Monetary Control Act of 1980, § 501 (DIDA) , codified at 12 USC § 1735(-7a. The Alternative Mortgage Transaction Parity Act of 1982 (AMTPA). 12 USC § 3800, et seq. 7See, e.g., pp. 7-10, infra. The portion of homeowners with home equity loans more than doubled between 1977 and 1988. In 1977, 5.4 percent of homeowners had such loans; in 1988 , 11 percent (6.5 million families) had home equity loans . Canner & Luckett, "Home Equity Lending," 75 Fed. Reserve Bull. 333 (May, 1989). In this case, where default was absolutely predictable and inevitable as of the first payment on a 12- month balloon note, the contract provided for extremely high late charges plus a 42 percent default interest rate. Thus, at the end of the 12 month term, the lender could claim a lien on the property that was approximately $50,000 greater than than the original principal plus 22 percent interest provided for in the note. 10In fact, state laws on foreclosure almost universally allow foreclosing creditors to buy the property at a significant discount from fair market value and then to resell it at full value, pocketing the difference. 315 tle capitalization base. They could obtain a line of credit from a major bank; originate predatory loans, taking out very high up-front fees; then dump the loans onto the secondary market. It is a good deal for an equity-skimmer who originates the loans, because it can charge enormous up-front fees, be careless about underwriting, and then pass the consequences along. Ifthe loan defaults, it is the new creditor's problem. Apparently the buyers on the secondary market thought it was a good deal: they'd save the expense of originating loans, and, if the borrower alleges the originator defrauded them, or engaged in usury or other violations of the law, they could hide behind a holder in due course defense.11 "Tax Reform:" The amendment of the tax laws which retained the deductibility of interest only for home-secured loans added to the massive increase in home-equity debt. Many consumers and taxpayers are not well -equipped to calculate how the tax savings would weigh against the extra interest to be paid. Yet that is a sales pitch given by many creditors, and many homeowners listen to that siren-call. Cultural & Business Mores: Finally, these economic and legal changes happened in a context of shifting cultural attitudes. The business ethic was that "anything goes," and greed was no longer the subject of opprobrium, but rather viewed as an engine for growth. Unfortunately, home equity lending became one of the targets for the speculators. THE VICTIMS The problem of second mortgage scams and home improvement scams is not limited to certain regions; we have seen them from most parts of the country.12 But there are certain factors which make it worse in some areas than in others: -areas which had the greatest increase in real estate values tended to have more problems; -the more permissive the legal environment (i.e. the less regulation), the greater the problem. Most poignantly, the more vulnerable the population, the greater the problem. Thus the less educated and less sophisticated are particularly victimized by these lenders; as are the elderly (who often have a lot of equity in their homes); and those whose other 13 borrowing options are blocked, or who perceive themselves as having no options.¹ THE PERPETRATORS When one looks at both the "sins of commission" and the "sins of omission," there is a great deal of culpability across the spectrum. " Tin Men:" Fraudulent home-improvement contractors, particularly the door-todoor operators, have long been a major source of complaint about abusive home-secured loans. They have been with us always, and probably always will. But as to whether they are isolated actors, or are commonplace depends upon whether the ultimate sources of the financing -and the regulatory environment-encourage or discourage oppressive business practices. In addition to needing a source of financing to run their business at the outset, these contractors must have an outlet for their credit sales , as they cannot afford to carry the credit accounts themselves. Thus they will either arrange for lenders to make direct loans, with the proceeds to pay off the sales ; or will write financing contracts themselves, to be immediately assigned by prearrangement to a lender. In some instances, it may be the ultimate financier who drives the operation, in essence using the contractor as a "bird-dog" to drum up mortgage business for it.14 These ultimate lenders can be second mortgage companies (which may or may not be regulated by the state); often they are finance companies (which are regulated by the state); or banks (which are regulated by either the state or a federal agency, 11 The holder in due course doctrine generally gives assignees or other subsequent holders of negotiable instruments (such as promissory notes) immunity against legal claims and defenses that the borrower may have had against the original creditor. (See also p. 11 , infra. ) Some also bought the loans with a recourse arrangement, whereby they would return non - performing loans to the originator, giving them yet further protection against risk-at least until the originator went bankrupt. 12 One exception is Texas, which has strict limitations on the kinds of home equity loans which can be written at all. 13This factor helps explain the disparate impact of predatory lending felt by minority borrowers and people living in minority neighborhoods. See, eg. "Abuses and Regulation," note 2, supra., Appx. B-"Race and Risk: High Rate Lenders for High Risk Borrowers -Myth or Fact?" 14 This was the heart of the claim in Baker v. Harper, in which a mortgage company was ordered to pay $45 million to 5 families. See "Alabama Jury Orders Lender to Pay $45 Million in Fraudulent Lending Case," 57 BNA Banking Rept. 270 (Ăug. 12, 1991). 70-832 O · 93 - 11 316 depending upon their charter). It is the cooperation of the ultimate financing sources which keep a contractor in business. Thus the lender is in a position to help assure that legitimate value be given for the money, or to help compound the problem by trying to disassociate themselves from any complaints the borrower may have about the contractor or his work.15 Unfortunately, many ultimate lenders, despite their heavy involvement in facilitating the transaction, choose the latter course.16 Second mortgage companies: As was noted above, the 1980s witnessed the growth of second mortgage lending companies-many of which received notoriety: Landbank Equity; First American Mortgage Company; Freedlander. In many states, these companies were not (and still are not) regulated. The earlier discussion about the secondary mortgage market explains how these companies generally operated. As with the "tin men," it is frequently regulated lenders-banks and thriftswhich provide the wherewithal for these companies to survive. Again, there are degrees of culpability among these "enablers." Some may actually know what kind of operation the second mortgage lenders are running; others simply choose to ignore the red flags in these transactions , and buy up the paper anyway 17 The more "the legitimate" lenders opt to purchase these kinds of loans with an “ostrich" approach to their investment, the easier it is for the predatory lenders to flourish. Finance companies: 18 Finance companies moved into home equity lending in a big way in the past 15 years. Some of the finance companies have been particularly bad at "loan-padding:"-inserting costly add-ons onto loans, making them much more expensive for borrowers.19 Finance companies are regulated (with varying degrees of success) by the states, but some are subsidiaries of banks, which, in turn, are regulated by either the states or a federal agency, depending upon their charter. The supporting cast: Mortgage brokers have played a major role in steering borrowers into bad loans. As their fees are a percentage of the loans, there is a "reverse competition" effect which encourages them to hook borrowers up with expensive, loan-padding lenders. Many of these brokers advertise as if they are market-rate lenders and do not disclose their true role-or their commissions-until loan closing. By that time many borrowers have lost their leverage to object or walk away. Loan brokers are not regulated in many states, and some regulation which does exist is token only. Banks and thrifts: As the above discussion indicates, even if banks and thrifts are not directly engaging in predatory business practices, it often is their ultimate financial support which enables the predatory lenders to operate on the scale we have seen in recent years. ALLOCATING RESPONSIBILITY To anticipate one reaction we've heard too often in telling of these loans, I'd like to make a few other observations. That reaction: "Well why do people get themselves into these deals? Don't they have to take some responsibility for what they sign?" There are a lot of reasons why that's not an appropriate response. • Most obviously, it blames the victim, while relieving the business of any ethical obligation, as ifthe public policy is that a lender can do anything it can get away with. After all, we prosecute burglars even if the apartment window wasn't 15 See, e.g. "Spiking and Loan-Splitting in Home Improvement Contracts: Artful Dodges," 26 Clearinghouse Review 415 (Aug. 1992). Where the sale of home improvement goods and services is involved, the Federal Trade Commission's "holder rule" ( 16 CFR 433) provides that a related financier has vicarious liability for any claims or defenses the consumer has against the seller. 16 More and more frequently, the same principals direct both sides of the business. But they try to disguise the connection, so as to try to claim the borrower's obligation to pay is distinct from the contractor's obligation to perform its part of the contract. 17 Unlike the home improvement sales financing contracts, the FTC " holder" rule does not apply to straight loans, so these assignees can try to assert a holder-in-due course defense to claims the borrower may raise based on the originator's wrong-doing. 18Finance companies, such as Beneficial, ITT Financial, etc, are what used to be thought of as “small loan" companies, though in many states today they can make relatively large, mortgage secured consumer loans. It has been our experience that finance companies tend to keep the home equity loans they make (refinancing them frequently), rather than using the secondary market. 19 "Insurance-packing" is one of the more common means of loan padding favored by finance companies. For a description of the practice, see National Consumer Law Center, Usury and Consumer Credit Regulation Chap. 7 ( 1987 and Supp.). For a good example of how it can distort the price of credit to a borrower, see Besta v. Beneficial Loan Co. of Iowa, 855 F.2d 532 (8th Cir. 1988). In that loan, insurance packing enabled the lender to skim an extra $3,000 from what was really a $1,400 loan. In one loan seen at the Center, the very same scheme was used to skim an extra $23,000 from a loan. 317 locked. We prosecute muggers even if the victim didn't bother to learn martial arts for self-defense. • Credit-especially given the credit fads of the late 1970s and 1980s- is enormously complex and hard for most people to understand. It is even more so for people with language barriers, educational barriers or any other of the multitude of barriers a lot of consumers face. A recent Consumer Federation of America consumer survey showed that though 70+ percent of respondents knew what the letters APR stood for, only half of them understood its significance as an indicator of the cost of credit. (Recent experiences with ARMS and consumer leases suggest that some credit products are so complex that even the employees of the financial institutions can't figure out what these contracts say.) • Even aside from the issue of the products being too complex to be described in easily understood terms, disclosure laws like TIL aren't as much help as they should be. In fact, for residentially secured real estate, TIL actually encourages distortion in disclosing the cost of mortgage credit . Because of the special treatment given closing costs and brokers fees by TIL (in some cases exacerbated by FRB interpretations) in real estate secured loans,20 unethical creditors are encouraged to pack a loan up with exorbitant costs that, on their face, are permitted by TIL to be excluded from the APR calculation.21 For these kinds of loans, TIL has become part of the problem, not part of the solution. Moreover, TIL disclosures are often not finalized until the time of the closing on a loan, by which time the borrower may have foreclosed other options, and no longer have the choice of walking away. Furthermore, contracts are not written in understandable language, and the sheer volume of paper is overwhelming. One transaction, for example, had at least 40 pieces of paper that the consumer would have had to wade through. (The vast majority of those 40 pages were not "government-mandated ." Lenders wanting lopsided protections and verbose lawyers are the primary culprits for this excess paper.) The prose isn't exactly targeted for an 8th, grade reading level, and on some of these transactions, the numbers can take a lawyer a day or more to sort out. • The dynamics of the sale must be understood as well. From our reports, some of these brokers solicit the customers, rather than being sought out by the customers. Like any good salesperson, they are well -schooled in retail seduction, and know how to gloss over their product's weak points. That is problem enough when piled onto all the other factors mentioned here, but it also must be remembered that, at least for most of us, the tendency is to trust people. If it is hard to figure out what's going on, it seems the proper thing to do to trust the nice man or woman who seems like he or she is trying to help you. Many people don't operate from the assumption that all business people are out to 20Many costs associated with these transactions would fall within the overall definition of a finance charge, except that they are specifically excluded from the finance charge because these transactions are secured by real-estate. 15 USC § 1605 , 12 CFR 226.4(cX7). To the extent the purpose of TIL was to disclose the full cost of credit to a consumer, there is absolutely no justification for some of the (cX7) exclusions. (The ones that were justified would be justified in the purchase money mortgage context, but not in the second mortgage context. In a cash transaction real estate purchase, title fees and abstract fees would be incurred, so these fees would be imposed in a comparable cash transaction, and therefore wouldn't be a finance charge. In a straight second mortgage loan, there is no comparable cash transaction .) When TIL was passed, second mortgage lending was more rare, and closing costs were small in relation to the loan amount, so the degree of distortion was less significant to a consumer. See generally Rohner, The Law ofTruth in Lending, § 3.03 [ 1 ] ( 1984). Additionally, the FRB interpretation as to brokers ' fees is arguably wrong, at least in some factual circumstances, but until a court declares the interpretation "demonstrably irrational," creditors will exclude the fee from the finance charge. ( 15 USC § 1605(aX3) declares a finders fee a finance charge, and nowhere in the statute is any exception to that authorized. Thus, where the broker acts as a finder for the lender, as many of these do, the fee should be a finance charge. But Official Staff Commentary § 226.4(aX2 )-3, while clearly in direct contradiction to § 1605(aX3) and thus not legally entitled to deference, offers the creditors a convenient haven. Though at least two court cases have offered courts the opportunity to address this issue, neither of them choose to do so, and the issue remains an open one.) So today, with the surge in home equity lending, the increased costs tacked on to these loans, exacerbated in the case of abusing lenders, the (cX7) exclusions and broker's fee interpretation are beginning to be the exceptions that swallow the rule. This undermines the usefulness ofTIL as an indicator of the cost and a tool for comparison shopping. 21 Regulation Z, § 226.4(cX7) does require that these charges be "bona fide and reasonable" in order to qualify for the exclusion, but that's of little help to a consumer at the outset . We grocery shop often enough to know what a bona fide and reasonable price for a loaf of bread is; most of us don't get mortgage loans often enough to know what a bona fide and reasonable price is for a brokers fee or an attorneys fee or a title search fee. 318 rip them off until proven otherwise, and we as a society should think hard before we decide we want our economy to operate that way.22 • And of course, one of the central questions raised by the distribution of these loans is to what extent, if any, the high-rate lenders' customers have alternatives. This public saga began with the allegation that predatory lending operated in a credit vacuum created when mainstream banks abandoned direct lending in minority neighborhoods. In response some creditors have asserted that these are high risk borrowers who could not get credit elsewhere, and that the high rates are justified by the high risks. Issues of redlining are for another proceeding, but there are some points we would like to make concerning the "high risk” allegations: -Most important, many of these borrowers are not in fact any riskier than others.23 There may be self-selection, with some people assuming they wouldn't qualify, or assuming that "regular" lenders don't want their business. Though some borrowers really may not have alternatives, many simply may believe they do not. (And in fact, the differences between market-rate lenders and high-rate lenders in their advertising campaigns and target markets may reinforce that belief.) -Some consumers actually may present increased risk of default. But the way some of these loans are structured, these creditors seem to opt for writing a more risky loan, instead of one that might have a chance of working out, in order to suck more equity from the home. As discussed earlier (p. 3), the more than ample security given by the home eliminates the kind of financial risk which might otherwise justify such high rates. -Finally, some of the consumers in fact could not get credit elsewhere-and perhaps should not. Whether the high-rate creditors are offering them a service or are simply making improvident loans to milk these people dry is yet another issue. Some of these loans are designed for failure-to simply suck out the last remaining equity in the consumer's home, leaving the consumer with nothing when the home is sold. High rates, loan packing, and unaffordable balloons all add to the notion that equity-stealing is too often the motivation. RECOMMENDATIONS The problem of predatory home equity lending has a multitude of sources, and the solutions will have to come on many fronts. NCLC has developed a catalogue ofrecommendations to address both the overall problem and individual pieces of the overall pattern. Following is a two-part appendix which contains full discussions of that catalogue, and for ease of reference, a summary thereof. While that list is comprehensive, it does not rank the suggested reforms in order of importance to consumers. So to conclude our remarks today, we would like simply to highlight those reforms which we think would be of greatest value in combatting the overall problem of predatory lending practices. • Interest rate ceiling and limitations on other charges. As a result of an anomalous mismatch between statutory usury ceilings and market rates in the late 1970s, the entire concept of rate caps became anathema to lenders and regulators. Consequently, we threw the baby out with the bath water. In 1827, the Virginia Supreme Court observed that "It has been a good deal the fashion of late, to decry the policy and justice of our laws regulating the rate of interest.... It may be permitted to observe, however, that if the experience of the ages, and the general opinion of mankind, deserve weight in legislation, their voice is in favor of usury laws. They have prevailed in all civilized countries, and in all time." 24 The experience of the "deregulation decade" simply proves the point. The experience proves that rate caps are needed to protect the trusting, the unsophisticated, the unwary, and the necessitous consumer from "the oppression of usurers and monied men, who are eager to take advantage of the distress of others" 25 now no less than 150 years ago. The 1970s problem of a mismatch between statutory cap and market rate is easily resolved by the imposition of a statutory ceiling which can float with a specified market-related index. 22 Some courts have considered this "trust no one" approach and rejected it as untenable. See, e.g. Northwestern Bank v. Roseman, 344 S.E.2d 120 (N.C. Ct. App. 1986), aff'd 354 S.E.2d 238 (N.C. 1987). 23 See "Race and Risk," note 2, supra. 24Whitworth & Yancy v. Adams, 5 Rand 333 , 335, 26 Va. 333 (Va. 1827). 25 Id. 319 Furthermore, the usury ceiling should be combined with limitations on additional non-interest charges (points, brokers fees, closing costs, credit insurance, bogus escrows, etc.), which will curb loan-padding. In the absence of a federal cap, the DIDA 26 should be amended to permit states to reintroduce rate caps on home equity loans should they choose.27 • Eliminate holder-in-due course status for assignees and purchasers of home equity loans. This will force the industry to do more self-policing. If holders will clearly be liable for the claims the borrowers have against the originators, they should more carefully screen those with whom they do business. That, in turn, should help dry up the financial lifeline that has enabled the predatory second mortgage companies to operate. There is already federal precedent for this: the Federal Trade Commission has eliminated the rule for the purchase of consumer goods or services. 16 C.F.R. § 433. (It thus already applies to home improvement credit sales, but does not apply to straight loans .) Congress also limited the holder rule somewhat for certain credit card purchases. 15 USC § 16661. The limitation on the holder rule certainly has not dried up the legitimate auto financing market, so there is no reason to assume that extending it to home equity loans would dry up the legitimate home equity lending market. • Define improvident lending and overreaching home equity lending as an unconscionable practice or an unfair practice, and provide a private remedy. The 1974 model Uniform Consumer Credit Code § 5-108 contains a provision which provides consumers relief against unconscionable conduct or unconscionable terms. Among factors to be considered in determining unconscionability are: -Belief by the seller, lessor, or lender at the time a transaction is entered into that there is no reasonable probability of payment in full of the obligation by the consumer or debtor. -The fact that the seller, lessor, or lender has knowingly taken advantage of the inability of the consumer or debtor reasonably to protect his interests by reason of physical or mental infirmities, ignorance, illiteracy, inability to understand the language of the agreement, or similar factors. It provides that courts may refuse to enforce an unconscionable agreement, or refuse to enforce any unconscionable term, or limit the application so as to avoid any unconscionable result. It authorizes injunction and actual damages. A similar provision in the model National Consumer Act provided for punitive damages as well. (NCA, 88 5.107(4), 5.304). As the attached appendix demonstrates, there is a wealth of steps -some major, some minor-that can be taken to address various aspects of this problem. But we feel that these are among the most useful to get to the heart of the matter. 26Note 5, supra. 27See p. 3, supra. It will be also necessary to assure that a state's law is not further subject to preemption by a sister state with less inclination toward consumer protection through the "exportation" doctrine as a result of recent interpretations of § 521 of DÌDA, 12 USC § 1831d. Cf. Greenwood Trust v. Commonwealth ofMassachusetts, 971 F.2d 818 ( 1st Cir. 1992). 320 APPENDIX REGULATORY REFORM FOR PREDATORY HOME EQUITY LENDING Summary Issue Alternatives 1. Federal encouragement of exorbitant rate HELS Amend 12 U.S.C. Sec . 1735f- 7a. 2. Federal encouragement of HELS with balloon payments , etc. Amend 12 U.S.C. Sec . 3800 . 3. Equity skimming A. Prohibit holder in due course status . B. Establish claim that it is unfair to lend so that payments overburden the consumer's income . C. Establish floating interest rate ceiling . D. Require disclosures to investors . A. Impose fiduciary duty on loan brokers . B. Include fees in Truth- in Lending finance charges . C. Enact maximum fee . D. Require early disclosure of fees . E. Require Truth- in- Lending disclosures by brokers . F. Require brokers to advertise that they arrange loans but are not lenders . A. Prohibit balloon payments generally . 4. 5. Unfair and deceptive practices by loan brokers Balloon payments and demand notes 321 6. 7. Credit insurance Costly refinancing B. Alternatively , provide a right to refinance a balloon payment . C. Amend Truth-in- Lending to require conspicuously disclosed demand clauses . A. Require credit insurance to be written on declining monthly balance basis . B. Require creditors to take competitive bids on credit insurance . C. Establish a 75 percent minimum loss ratio for credit insurance . D. Establish maximum rates for credit insurance . A. Prohibit mandatory loan consolidation . B. Establish an unfair and deceptive practice claim for requiring imprudent refinancing . c. Require lender disclosure of disadvantages of refinancing . D. Require lenders to provide consumers a choice of a consolidation HEL, a HEL without refinancing , and unsecured credit . 8. Closing costs on home equity loans Amend Truth-in- Lending to include HEL loan closing costs in finance charge . 9. Wraparound mortgages Prohibit wraparound mortgages , or require the amount financed to include only actual advances for Truth- in Lending and usury purposes . 10. Prepayment penalties Limit to one month's interest . 2NDMTGAPP 322 11. Punitive foreclosure laws A. Establish right to cure delinquency . B. Amend Bankruptcy Act , 11 U.S.C. Sec . 1322 ( b ) ( 5 ) to allow cure until a bona fide sale of home occurs , and to authorize cram-down . C. Require private sale of foreclosed residence . D. Require notice of redemption right . E. Establish a mortgage assistance loan program. F. Allow moratoria on payment of principal . 12 . Lender pockets property insurance proceeds . Allow homeowner to decide whether to apply insurance proceeds to home or loan . 13 . Untimely disclosures . Provide advance disclosures . 2NDMTGAPP 323 ALTERNATIVES FOR HOME EQUITY LOANS (HELs) REGULATORY APPROACHES¹ DISCUSSION 1. Issue: Federal Encouragement of Exorbitant-Rate HELs. Problem: There has been a dramatic increase in predatory HEL lenders who encourage homeowners to take out large HELS at high annual percentage rates. Many of these mortgages are really first mortgages, particularly when the homeowners are elderly, because the homeowners' prior mortgages have been paid off. Under § 501 of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA),2 these HEL lenders were inadvertently set free to gouge consumers. DIDMCA was intended to repeal state usury laws which, because of high market interest rates, were impinging on home sales. However, it was written too broadly because it applied to any "first lien on residential real property," whether it was to be used for purchase or not. Unscrupulous HEL lenders use this loophole to target consumers with a lot of equity or to require homeowners to pay off existing low-rate, purchase money mortgages with high-rate HELS. Alternative: Amend DIDMCA to limit it to first liens taken to secure a loan for the acquisition or construction of a residence or to first liens taken to refinance such loans if the annual percentage rate on the new loan is at least two percentage points lower than the interest rate associated with the original loan. 2. Issue: Federal Encouragement of Balloon Payments, Negative Amortization, Demand Clauses. Problem: Another sweeping federal preemption of state consumer credit laws became effective on October 16, 1983 with the 1982 Depository Institutions Act. The primary preemption in that act is contained in the Alternative Mortgage Transaction Parity Act (AMTPA), 12 U.S.C. Sec. 3800. AMTPA does not affect interest ceilings on mortgage loans, but rather addresses the structure of mortgage loans by overriding state laws that restricted "creative financing," e.g., laws limiting variable interest rates, balloon payments or negative amortization . AMTPA, like DIDMCA, applies to HELs as well as mortgages to acquire a home, though the purpose of AMTPA, as well , was to encourage home construction and home purchases . In addition, AMTPA applies to any mortgage regardless of priority. Like DIDMCA, it has thus repealed traditional regulation by the individual states of the terms and conditions of consumer credit transactions that are secured by a family home. This preemption prevents states from taking such traditional steps as putting annual or lifetime caps on variable interest rates, limiting or prohibiting balloon payments (see Issue 5 below) or negative amortization³ and limiting prepayment penalties (see Issue 10 below). Alternative: Amend AMTPA to limit it to first and second liens primarily for the acquisition or construction of a residence, or to refinance first liens at an annual percentage rate that is at least two percentage points lower than the interest rate associated with the original liens. 3. Issue: Equity Skimming. Problem: Equity skimming may come in several guises. It may involve writing a home equity loan that is likely to be unaffordable by the consumer: either the regu lar payments are too high for their income, or low regular payments lead to a final balloon payment that the consumer does not have the resources to pay. It also may be "padding" the loan with unnecessary and costly charges of no benefit to the borrower in order for the creditor to extract more of the home's equity, either through the borrower's repayment of the padded loan or through foreclosure in the event of default. NCLC first started observing equity skimming loans in the late 1970s and early 1980s when many states began deregulating consumer credit laws. Some equity skimmers were most interested in obtaining a quick foreclosure sale of consumers' homes, which they could buy and then sell for a large profit . Others were engaged in what resembles a classic Ponzi scam. That is, they were in the business for the short-term , extending credit with large front-end charges and high interest rates, using underwriting criteria unlikely to prevent many defaults and foreclosures, and then selling the mortgages to investors attracted by the high interest rates . They ' This is adapted from Hobbs, Keest & DeWaal, "Consumer Problems with Home Equity Scams, Second Mortgages, and Home Equity Lines of Credit,” (AARP, 1989). 212 USC § 1735f-7a. This occurs when the monthly payments are insufficient to meet the accruing interest on the loan. This results in an increasing loan balance even though installments are timely paid. 324 would collect payments ("servicing") for the investor. (As with other Ponzi schemes, these sometimes collapsed into bankruptcy.) Finally, those who skim simply by loanpadding are trying to extract extra wealth from the vast real estate equity pool for themselves, without giving any real additional benefit to the borrower for the added cost. Alternatives: A. "Holder-in-due course" status prevents the investor/assignee from being subject to claims and defenses, e.g., fraud or usury claims, which the borrower might have against the original lender. Removing holder in due course status for home equity loans would put the burden on investors to make sure that they investigate the lender before they purchase the paper. With such investigation, financing for predatory lenders dries up. While it is not clear that equity skimmers' investors could technically prove they were holders in due course in a court proceeding, this is generally the investors' first line of defense when a consumer tries to protect the family home by suing for fraud or other claims. The Federal Trade Commission's "Holder Rule," 16 C.F.R. Sec. 433, abolished holder in due course status for consumer credit sales in 1976. Because the FTC's rule was fashioned before the rise in HELS, the need to cover consumer loans was not considered. Legislation modeled on that rule, but applied to HELS, would help to dry up the sources of funds for home equity skimmers. B. An additional approach is to make it an unfair practice to extend a home equity loan to a consumer if the payments on the HEL, together with the other debts which the consumer owes, are equal to or more than 40 percent of the consumer's net income, or otherwise prohibit improvident lending." Most lenders would consider a 30 percent ratio of debt to income to be a dangerously high level of debt. This prohibition would give consumers a claim against the lender who pushed the consumer into insolvency. An individual's right of action, similar to that provided in the Truth-In-Lending Act, or model statutes such as the 1974 Uniform Consumer Credit Code would be necessary. C. The most effective approach would be statutory interest rate ceilings, combined with prohibitions or restrictions on non-interest charges, e.g., points, brokers' fees, service charges, unearned interest, late charges. Effective yields on predatory HELS are presently in the range of 20 percent to 23 percent or higher, a rate well above legitimate lending. A floating statutory ceiling which gives a yield just above the level charged by legitimate lenders may be the most workable. D. A fourth-though weak-approach would be to require the home equity lender to provide investors with a disclosure statement describing the investment, modeled after the requirements of the Securities and Exchange Act, which might include an independent appraisal of the property, the underwriting criteria applied by the lender, and how the consumer met those underwriting criteria. For this approach to have any effect, state or federal regulatory officials would have to regularly examine such lenders and statements. 4. Issue: Unfair and Deceptive Practices by Loan Brokers. Problems: Loan brokers are people who offer to find credit for consumers who believe they cannot find it on their own. The business does not seem to take place at all in some states while it flourishes in others. Loan brokers charge a large fee, usually calculated as a percentage ofthe loan, often doing little or no work at allat least not for the consumer's benefit. (They may do a lot of work for the creditor, acting as a "bird-dog" to flush out business for one or two lenders with whom they have pre-existing relationships .) Creditors guard their underwriting criteria and do not make them generally available to the public. Consumers must apply for credit to determine whether they qualify. Theoretically, loan brokers match borrowers and lenders by knowing the details of lenders' underwriting criteria, but generally home equity brokers simply funnel consumers to their related lenders, who do the actual credit screening. For this they charge a fee of hundreds and sometimes thousands of dollars. Since loan brokers' fees are often based on the amount of the loan to the consumer, the broker has an incentive to increase the loan size. Thus there is "reverse competition" operating, encouraging the broker to steer the borrower to lenders who engage in loan-padding. Also, he or she may encourage the consumer to refinance or consolidate debts that should not be refinanced because of prepayment penalties, partial rebates of unearned finance charges, or front-end charges. In some instances loan brokers have encouraged consumers to refinance low-rate debts with high-rate credit they arrange. Such refinancing may cost the homeowner thousands of dollars in additional finance charges, often with higher monthly payments. Loan brokers are usually paid their fee directly by the lender out of the consumer's loan proceeds. This reduces the consumer's cash from the loan: it also makes 325 the annual percentage rate lower because, under the Truth-in-Lending Regulation Z, a loan broker's fee is usually not counted as a part of the finance charge. Thus, brokered loans appear to have a lower APR than loans that are not brokered, which is deceptive. (Perhaps to take advantage of this, we have seen lenders pay "brokers's fees" where no broker was used by the consumer. ) The broker's fee is a cost of credit to the consumer, and should be included in the finance charge. Often, the consumer first realizes the size of the broker's fee only upon receipt of the Truth-in-Lending's itemization of the amount financed . The problem is worse if the person actually extending credit is a private investor who makes fewer than 6 real-estate secured loans a year, as no TIL disclosures are required at all then. Some loan brokers advertise as if they were a lender and deal with the consumer in ways that hide their role. Consumers do not expect a "broker's commission," because they did not know they were dealing with a broker. And because many loan brokers operate their loan brokerage as a sideline to other business real estate, working for a lender, a law practice further confusion is created about their role. Alternatives: A. Impose upon loan brokers a fiduciary duty to use reasonable efforts to obtain financing at the lowest available rate for the consumer and for an amount that is in the consumer's best interest. Through the fiduciary duty, prohibit a loan broker from encouraging a consumer to refinance credit when the refinancing is disadvantageous to the consumer's financial interest. Breach of fiduciary duty can give rise to a legal claim by the borrower. B. Amend the Truth-in-Lending Act to require that loan broker fees be included in the finance charge. C. Enact a maximum fee for loan broker charges. D. Require that a loan broker disclose the method of determining, or the amount of, the broker fee before the consumer is obligated to use the loan broker's services. More preferable is to require written contracts between brokers and borrowers which set out the brokers fees and responsibilities in advance. E. Require brokers who arrange home equity loans to provide Truth-in- Lending disclosures ifthe creditor is not required to make Truth-in-Lending disclosures . F. Amend the Truth-in-Lending Act to require a loan broker's advertising to conspicuously state: "[ name] is not a lender. This is an offer to arrange a loan." 5. Issue: Balloon Payments and Demand Notes. Problem: Many predatory HELs include a balloon payment. A balloon payment is a payment substantially larger than the other installments-usually the final payment. It is not uncommon to see balloon payments in HELS that exceed the amount that the consumer actually borrowed because of other charges or negative amortization.* A demand note contains a clause allowing the lender to demand payment of the full balance at some point prior to the scheduled maturity. For example, the contract may be set up as a 10-year note, but buried in the contract is a clause allowing the creditor to call the loan in 3 years. Through the 1970s most states prohibited balloon payments and demand clauses in consumer credit transactions, either by requiring that all payments be in substantially equal installments or by expressly prohibiting balloon payments and demand clauses. AMTPA repealed those prohibitions of balloon payments and demand clauses for home equity loans . (See Issue 2, above .) Most consumers plan to play their installment credit from future income and do not have sufficient savings to make a balloon payment or demand payment. A balloon payment or a demand for the balance by the lender puts the family in a position of either having to refinance their home equity loan (if they can find a willing lender) or losing the home. In many cases, predatory lenders use the threat of an unaffordable balloon to force refinancing at a higher rate or otherwise making it more costly with added penalties and costs . This subsequent loan just sinks the consumer deeper in unmanageable debt. Alternatives: A. The most restrictive approach would prohibit balloon payments and demand clauses on home equity loans. This could be done by federal or state law. Alternatively, they could be prohibited unless the balloon payment could be met from the consumer's reasonably anticipated future liquid assets or income. B. If a HEL contains a balloon payment, the consumer should be given the right to refinance, without penalty, the amount of that payment before or at the time it is due. The terms of the refinancing must be no less favorable to the consumer than the terms of the original transaction. This is the general approach of the 1974 Uni- *See note 3, supra. 326 form Consumer Credit Code, which has been enacted in some states, as proposed by the National Conference ofCommissioners on Uniform State Laws. C. Amend the Truth-in-Lending Act so that the effect of a demand clause is prominently displayed in or near the disclosure of the scheduled payments in a home equity loan, instead of being cryptic and buried, as is presently permitted. 6. Issue: Credit Insurance. Problems: Selling high-priced insurance in connection with consumer credit transactions has been a problem for decades. "Reverse competition," profit to captive insurers and greater interest on the insurance-padded principal all provide strong incentives for creditors to push insurance onto consumers. Credit insurance premiums-priced in most states unreasonably and unjustifiably high -can amount to thousands of dollars when written in connection with a large, long-term home equity loan. We have seen home equity loans with $ 10,000 in insurance premiums. (See National Consumer Law Center, Usury and Consumer Credit Regulation Chap. 7 (1987 and Supp. ) for more detailed explanation ofcredit insurance problems. ) Credit insurance premiums (including the commission portion) are usually considered part of the amount financed under TIL, so the presence of large insurance premiums can distort the APR, making the credit look cheaper than it is. Alternatives: A. While regulation of credit insurance rates has traditionally been a state function, Congress should legislate nationally on this issue. One step which might help is to require "net coverage," which would prohibit insuring unearned interest, as is common now. B. Massachusetts formerly pioneered a free-enterprise approach of requiring state banks that offer credit life insurance to take competitive bids from insurance companies for underwriting their credit insurance. They were then required to accept the lowest-priced credit life insurance with acceptable coverage and underwriting for sale to their borrowers. This could be adopted by other states or Congress. C. Credit insurance could be required to be written so that the loss ratio is no less than 75 percent. Many states have loss ratio requirements, though they are generally too low and even then are rarely enforced. D. Provide for a genuinely reasonable maximum rate. 7. Issue: Costly Refinancing. Problem: Most of the second mortgages extended by finance companies or second mortgage companies are what the industry would call "consolidation loans." That is, the consumer has used a substantial portion of the, loan proceeds to pay off other creditors, in many cases contrary to the consumer's financial interests. The refinancing of existing credit may be disadvantageous to the consumer in several ways. A low-rate loan may be paid off by a high-rate loan; the new payment maybe higher than the old payments combined. Front-end charges, prepayment penalties, failure to rebate unearned interest or use of the Rule of 78s make the actual remaining cost on an annualized basis of the existing credit less than the annual percentage on the new home equity loan. (This may be true with "same-creditor refinancing, as well as consolidation lending.) Finally, in most instances, it is to the consumer's disadvantage to use a home equity loan to pay off debts that do not threaten the consumer's home, e.g., a medical debt or a car loan. Ifthe consumer is unable to keep up with the payments on those transactions, the home would probably be protected by state homestead exemption laws or the federal bankruptcy code. However, a home equity loan would waive those protections (except in Texas), thereby putting the consumer's home at risk of a foreclosure and sale at a distress sale price. Alternatives: A. The most extensive protection would prohibit a home equity loan lender from requiring a consumer to pay off preexisting debts as a condition of extending credit unless the pre-existing debt is secured by the residence and has an interest rate higher than the annual percentage rate on the new home equity loan. B. An alternative to A. would make it an unfair and deceptive practice, with a private right of action, for a HEL lender to require a consumer to pay off pre-existing debts where the pre-existing debt was not secured by the consumer's home, or The commission to the creditor is greater from more expensive insurance, thus giving creditors incentive to sell consumers higher- priced insurance. Finance companies and other lenders may take 40-50 percent of the premium as commission. Many of the major finance companies now have affiliated insurance companies whose products they sell, thus keeping the considerable profits "all in the family." ' One recent study estimated that consumers were overcharged $1 billion per year just on credit life insurance alone. 327 the annualized future cost of the pre-existing debt was less than the effective rate offered under the home equity loan, adjusted for any income tax savings. C. Require a lender who refinances existing debts with a home equity loan to disclose to the consumer the disadvantages of refinancing the existing debt. This would involve a disclosure comparing the total finance charges, the amounts financed, the payment schedules, the total amount to be paid, and the collateral on the existing debt with those for the proposed new loan. D. Where a lender requires or offers to refinance existing debts with a home equity loan, the lender should also be required to offer the consumer an additional alternative: an extension of credit that does not refinance existing debt. 8. Issue: Closing Costs on Home Equity Loans. Problems: Regulation Z, 12 C.F.R. Sec. 226.4(c)( 7), allows the exclusion of closing costs from the finance charges if they are bona fide and reasonable in amount. There has been almost no examination of the reasonableness of closing costs under this standard, and they are always added to the amount financed . This can distort the APR, which is what consumers are taught to look to as the "price tag" for the credit. A creditor who pads the closing costs thus might show a lower APR than one who doesn't, even though overall its loan is more expensive. This is not "truth" in lending. Alternatives: Amend Regulation Z to require that closing costs for home equity loans are included in the finance charge. 9. Issue: Wraparound Mortgages. Problem: A wraparound mortgage is a second mortgage which obligates borrowers to make the payments on the first mortgage through the second mortgage lender; the wraparound mortgage could be a third or lower mortgage requiring payments on all or some of the higher mortgages to be made through the wraparound mortgage. For Truth-in-Lending purposes (as well as usury purposes under many state laws), the amount financed for the wraparound mortgages is considered to be the sum of the amount actually lent by the wraparound mortgage lender plus the remaining balance on the first mortgage. This is permitted even though the wraparound mortgage lender does not advance any funds on the first mortgage. The usual Truth-in-Lending result is that the annual percentage rate considerably understates the actual cost of the wraparound mortgage to a consumer. In effect, the wraparound mortgage offers a way to avoid consumer comparison shopping and state usury limitations. Alternative: Wraparound mortgages in consumer credit transactions could be prohibited by federal or state legislation. Alternatively, Truth-in-Lending and state usury laws should require that to calculate the annual percentage rate and interest rate, the amount financed be composed only of the amounts actually advanced. 10. Issue: Prepayment Penalties. Problem: It is not unusual for home equity loans, particularly second mortgages, to require the consumer to pay a penalty for prepaying the home equity loan. This is a way that lenders, particularly high-rate lenders, try to create captive customers by making it too expensive for consumers to refinance elsewhere at market rates. (Particularly unscrupulous creditors may encourage unsophisticated borrowers to do an in-house refinance, and pad the loan balance by adding in the penalty.) Alternative: Limit prepayment penalties to no more than the amount of interest that would accrue on the payment following the prepayment. 11. Issue: Punitive Foreclosure Laws. Problem: Most states strictly enforce the acceleration clause in a mortgage that allows the lender to demand the balance of the debt for any default, which is generally defined as the failure to pay any single installment on time. It may also include allowing the collateral to depreciate or failing to abide by any other term of the mortgage . When a mortgage lender forecloses, most states allow the property to be sold at a sheriff's sale, at which the lender generally buys the property for the balance of the outstanding mortgages. If it is a home equity loan, the foreclosing lender generally buys the home for the amount of first mortgage, thus paying off the first mortgage holder. The lender is then free in most states to resell the property in the private market for fair market value and pocket the profits. Alternatives: A. Homeowners should be given a right to cure (the right to bring their mortgage current and reinstate their right to pay it in installments). Many states already allow delinquencies on other consumer credit transactions to be cured by the 328 consumer making up missed payments. Federal regulations under DIDMCA also extend the right to cure to mobile home owners. B. The federal Bankruptcy Code allows debtors to cure by repaying their debts through a Chapter 13 bankruptcy, 11 U.S.C. Sec. 1322(b) ( 3). The courts are divided on how soon a Chapter 13 bankruptcy must be filed in order for the consumers to forestall a foreclosure and cure a default on a mortgage. The bankruptcy code could be amended to provide for a cure up to the point that the residence is sold to a bona fide third party and state redemption rights have expired. C. The Bankruptcy Code currently provides special protection from modification for all creditors "secured only by a security interest in real property that is the debtor's principal residence." 11 U.S.C. § 1322(b) ( 2). This provision has been invoked by home equity lenders with no legitimate right to protection ahead of other secured and unsecured creditors. The Bankruptcy Code should be amended to eliminate special protection for home mortgages other than purchase money mortgages and refinancings of purchase money mortgages made at least two percentage points lower than the original loan. Bankruptcy debtors would then be able to use their full panoply of Chapter 13 options to avoid foreclosure of HELs by payment in the bankruptcy process. D. Adequate sale prices upon foreclosure would be encouraged if a foreclosure creditor is required to have the property listed for private sale with a realtor in the same fashion as any voluntary home sale. Some type of legal supervision of this sale would be necessary. Possibilities for supervision include a judge, a court-appointed receiver or an arbitrator. When a dispute arises (such as whether to accept an offer to purchase or wait for another offer), the judge, receiver or arbitrator would resolve the dispute. E. Homeowners should be provided with a notice explaining that they have a redemption right, and that they can sell the redemption right to a buyer who can exercise that right. They should be informed that this is a way to recover their equity that would otherwise be lost in the foreclosure sale. The former homeowner could use these rights to get a fair value for the home rather than the foreclosure distress price. F. The establishment of state mortgage payment assistance programs, such as those adopted by Pennsylvania and Maryland and considered several times in Congress in the past decade, is another solution to foreclosure problems. These are revolving loan programs that lend money to temporarily distressed households to pay part of their mortgage payments. The loan is usually for a limited time, e.g., three years in Pennsylvania. After that, the consumers are obligated to repay the mortgage assistance loan. This has been especially helpful to displaced workers and to other debtors who suffer temporary financial setbacks caused by illness, divorce, temporary disability, death of a wage earner, etc. G. Moratoria laws, which were used a great deal in the Great Depression and by several states in the recession during the 1980s, allow homeowners to avoid foreclosure as long as they pay the current interest on their mortgages. The moratorium is on payment of principal. These laws may be triggered by a household's financial distress or, more commonly in modern times, by an economic emergency. 12. Issue: Lender Pockets Property Insurance Proceeds. Problem: Mortgages generally require the homeowner to maintain casualty insurance on the property. The consumer is generally not required to purchase such property insurance through the lender, although it is usually required that any insurance procured elsewhere be acceptable to the mortgage lender. Requiring property insurance is generally felt to be prudent to prevent a loss if a catastrophe happens to the home. However, most mortgages, whether for purchase money or a home equity loan, also contain a clause requiring the lender to be named the insurance loss payee and allows the lender to apply the proceeds either to the balance of the debt or to the repair of the home. If the lender applies the insurance proceeds to the balance of the debt, there may still be a debt outstanding on a home that remains damaged. The consumer receives no insurance proceeds in that situation to make the necessary home repairs. When mortgage interest rates are low, there are very few complaints of mortgage lenders pocketing insurance proceeds to pay off mortgage debts. However, the last time mortgage interest rates were high, there were many complaints of mortgage lenders paying off older, low-rate mortgages with insurance proceeds because of the rising mortgage rates generally. Because of that, the home became uninsured against casualties. These statutes may allow a creditor to charge a reasonable attorney fee if collection efforts were actually undertaken by an attorney. 329 Alternative: Legislation could be enacted to permit future homeowners to choose whether to apply property insurance proceeds to repair the insured property or to the loan balance. 13. Issue: Untimely Disclosure. Problem: The fundamental flaw in the Truth-in-Lending disclosure approach is that disclosures are made too late in individual credit extension: when consumers are too psychologically bound to the transaction to reject it, their shopping and negotiation costs have already been incurred, and the lure of the credit advance and fear of the lender's scorn are too immediate for most consumers to reject credit on the basis of a Truth-in-Lending disclosure statement. By regulating advertising and oral quotations of rates, Truth-in-Lending has improved the ability of consumers to shop and the market to compete on the basis of rates, but further improvements can be made to foster both consumer shopping and rate competition. Alternatives: A. Require the Federal Reserve Board to conduct surveys of lenders' annual percentage rates on HELS and make the resulting shoppers' guides available to consumers and to the press. A pilot project by the Federal Reserve Board indicated that such guides would save consumers millions of dollars by fostering lower credit rates through competition on some types of credit. B. Require basic credit information, including the proposed APR, amount financed, finance charge, payment schedule, and total of payments, to be disclosed to the consumer at the time of application. Congress requires this approach for credit cards and home equity lines of credit. TESTIMONY BY TERRY DRENT, HOUSING COORDINATOR, COMMUNITY DEVELOPMENT DEPARTMENT, CITY OF ANN ARBOR, MICHIGAN FEBRUARY 17, 1993 Problem Many people living on fixed incomes in Michigan and the rest of the country are facing a crisis. For many the cost of medical care, housing, and basic sustenance is so high that they have to supplement their incomes with debt in order to survive. In southeastern Michigan, we are seeing many low income families, senior citizens, and disabled people who live on fixed incomes being preyed upon by unscrupulous mortgage companies. These firms often target lower income families claiming to be able to assist them in paying for medical care, home repairs, and property taxes. The results, however, can lead to the misery and impoverishment of this population. Many of these victims are suffering great hardships because of the financial "solution" offered by mortgage companies, and it has increased the burden on limited community resources. Some people are actually being forced out of their homes. Background People living on fixed incomes are susceptible to abuse by mortgage companies because they have seen their expenses for vital items increase at a rate greater than their incomes. Social security has increased at an average rate of 3.5 percent a year over the last four years. Medical costs have increased by 15 percent to 20 percent in the same period . Senior citizens alone account for 40 percent of all hospital stays and have many needs not met by any insurance company. If you are a diabetic or have cancer, you need an expensive special diet. We have seen diabetics saving needles in a coffee saucer filled with rubbing alcohol because they can't afford to buy new needles. When these fixed income individuals are homeowners, the burden is greater because of the need to make repairs on their home. If a furnace breaks it has to be fixed. Additional repairs or remodeling must be completed to accommodate a sick spouse or physical limitations of the homeowner. Increasing health problems can create home accessibility needs. Lowering bathroom fixtures and cupboards and building ramps and railings is a very expensive undertaking, though less so than hospitalization. An additional problem is the increase in property taxes over the last several years as localities and school districts continue to face budget imbalances, some due to cuts in Federal funds. Lower income families have less and less disposable income and are being forced to make difficult choices. They must often choose between paying their medical bills or buying food, paying for a special need for themselves or an ailing spouse or paying property taxes, paying for home repairs or paying their property taxes. Like most ofus they choose to pay for their basic needs, and the property tax bill is usually the one that goes unpaid. 330 In Michigan and many other states, if you are unable to pay your property taxes, the state will collect them by selling them at the annual tax sale. Anyone can purchase these back taxes, from individuals to private companies. The tax purchaser will pay one year of the homeowner's taxes and get a lien on the property. After a redemption period they will get a deed to the house. As a result of these transactions, the homeowner loses everything, including all of the equity they have built in his or her home. The tax purchaser can then sell the home at its market value. ABC's Good Morning America did a program on this topic that aired on September 24, 1992. A second means of conducting business is more complicated and insidious than the first. It starts with the tax purchasers, or tax lien buyer. Purchasing taxes is a big business and many companies as well as individuals are involved. The tax lien buyer will purchase the taxes and get a lien on an individual's home. They then contact the homeowner and inform him or her that unless the purchased taxes are paid in full, the home will be foreclosed upon. They then offer a deal-if the homeowner is unable to pay the full amount, the company will arrange a monthly payment plan that will allow the homeowner to stay in his or her house. Because the homeowner is desperate to remain in his or her home, the deal is agreed upon. The tax purchaser then refers the homeowner to a mortgage company, which the tax purchaser actually owns. The mortgage company will then exchange the tax lien for a mortgage. Again, the mortgage offered is generally double the market rate with very high administration and processing fees. The homeowner gets a mortgage he or she cannot afford to pay and over time the mortgage company forecloses. This can be an acquisition strategy on the part of the tax purchasing companies. It is quicker and cheaper to foreclose on a mortgage than to perfect title with a tax deed through the courts. In Michigan, personal notice of a foreclosure is not required, and foreclosures are an administrative process, not a judicial proceeding. The notice is only published in the Legal News, which even few lawyers read, and the property is listed by its legal description, not by address. With the administrative foreclosure, the mortgage company can merely present an affidavit to the sheriff to have the homeowner evicted. In Ann Arbor, an elderly widow with Alzheimer's disease was confronted by a County Sheriff's Deputy with eviction papers of which she had no understanding. She was forced to move out of her home. A tax purchaser obtained her home for approximately $3,200 in back property taxes and later sold the home for $95,000. This women saw none of the proceeds from the sale of her home. She eventually ended up in a State Psychiatric Hospital that has since closed due to state budget cuts. The City of Ann Arbor's Community Development Department had been working with another elderly widow with Alzheimer's disease. She was unable to pay her property taxes and subsequently they were purchased. Home Loan Financial Corp., a subsidiary of Birmingham Bancorp Mortgage Corp., obtained her name from the delinquent tax roll published by the County Treasurer's Office and offered her a loan to pay all of her back taxes. The mortgage company discovered that the Community Development Department of the City of Ann Arbor had a lien on the property for rehabilitation work completed several years earlier. The mortgage broker asked the city to subordinate to the new mortgage, which they were negotiating. The broker told the senior citizen and her daughter that they needed to act quickly or a tax purchaser would take the home. He put a good deal of pressure on these people to sign his note, calling them three or four times a day. He was also upset with the city staff for becoming involved and alleged we were obstructing his business. We discovered that although this homeowner needed approximately $ 13,000 to pay her delinquent taxes, the loan amount offered was for $35,000 at 18 percent interest. Her monthly income was $770 and was derived from Social Security. Her mortgage payment would have been $680 per month before taxes. She would have been left with $90 per month on which to live and still have to make property tax payments. This homeowner's case was presented to Great Lakes Bancorp, a local bank, and was approved under the Community Reinvestment Act. The homeowner was able to obtain a mortgage of $ 15,000 at 9 percent with monthly payments of $326 per month which included a property tax payment. Community Development staff also assisted a disabled Vietnam veteran. His deceased mother left him her home, which had a mortgage payment of $348 . He could not afford his increased property taxes and they became delinquent. He, too, was contacted by a representative of Birmingham Bancorp Mortgage Corporation, and agreed to a mortgage at 22.5 percent with a monthly payment of $980 dollars before property taxes. His disability income was $ 1,050 per month. He was facing foreclosure after 60 days of signing the note. Again, Great Lakes Bancorp, mindful of the Community Reinvestment Act, helped. He was approved for a 7.125 percent loan, and Great Lakes escrowed his property taxes to insure payment. 331 There is also a case of a 77-year-old widow in Whitmore Lake, Michigan, who could not pay her medical bills and her property taxes. A mortgage company got her name from the delinquent tax role published by the Washtenaw County Treasurer's Office. In 1989 this woman received a $ 12,729.50 mortgage at over 25 percent interest. Her monthly mortgage payment without property taxes was $350 per month, and her monthly income was $520, derived solely from Social Security. The loan had a three year balloon payment, and eventually the woman defaulted. The mortgage company refinanced the loan with similar terms, and after she defaulted, they again refinanced. Her debt increased from the original $ 12,729.50 to $39,500 within eighteen months. The woman actually received only $4,066 from these two additional transactions, the rest going to pay points and administrative fees. This senior citizen could not read the mortgage documents she apparently signed because of poor eyesight, and she did not understand the mortgage process . She had neither a checking nor savings account. In the court agreement negotiated with the mortgage company, the woman has eight months to refinance the total debt so she does not lose her home of over forty years. In Ypsilanti, Michigan, a 40-year-old mentally disabled man owned a home his mother left him "so he would always have a place to live." But his property taxes increased more than the disability income he received from the state, and he became delinquent in his property taxes. A property tax purchasing company bought the taxes and traded the lien on his property for a mortgage. His mortgage payment was $250 a month before property taxes; his monthly income was $220 . The annual interest rate on the note he signed in March, 1992, when mortgages were available for 8.5 percent, is over 21 percent. He is currently borrowing from family and friends to make his mortgage payment, and he spends approximately $25 per month for food. This year his property taxes will increase over 10 percent. He is less than a step away from becoming one ofthe homeless mentally ill. In Adrian, Michigan, an elderly person bought a home on a land contract subject to a mortgage to be paid by the land contract seller. The seller defaulted on the mortgage and the land contract purchaser was evicted. Without personal notice and a judicial foreclosure she had no knowledge of these proceedings until she was told to vacate the premises . There are many abuses in the non-conforming mortgage market, and what was once considered usurious mortgages are now allowable under current law. Many lower income homeowners are being victimized. We are not against non-conforming mortgages, in fact, the Mayor and Administrator of Ann Arbor, along with City Council, are currently trying to develop a loan pool with local banks under the Ann Arbor Credit Enterprise initiative to write non-conforming mortgages to help low income individuals obtain housing. However, we feel that there are consumer protections than can be put in place to help protect the low income, vulnerable, and disadvantaged, from an unchecked and under-regulated segment of the banking industry. We recommend the following for your consideration. Recommendations • Repeal exemptions from state usury laws in the Federal Banking Statute. • Establish a Federal Usuary Law, regulating interest rates as a specific percentage above prime rate and controlling the total financing charges imposed. • Strengthen and clarify the notice of foreclosure prevention services existing in current law. • Require personal notice of foreclosures to all significant interests in the property. • Require judicial foreclosure of all mortgages. • Amend the Older American's Act to require that low income senior citizens be referred to social service agencies before their property can be foreclosed. Summary The problem of reverse red-lining mortgages, along with the threat of tax foreclosures, is so severe in the City of Ann Arbor and the State of Michigan, that our Mayor, along with the City Administrator and City Council, has established a foreclosure fund to help our citizens with this terrible problem. But we have far too few dollars to meet the need, and many people are falling through the gaping holes in the small safety net that we can afford to throw out. As President Clinton is telling the nation today, these are austere times for Federal, State and Municipal government. We have less money to spend on the seemingly insurmountable problems facing our nation. Legislative action is needed to take care of this abusive mortgage system, which was largely created by the Depository Institutions Deregulation and Monetary Control Act of 1980. The practice of reverse red-lining mortgages is threatening the sanctity of part of the American dream, home ownership, for those 332 who can least afford it. This activity is wrong, unfair, and unjust; it must be stopped. STATEMENT OF JOHN P. HAMILL, PRESIDENT, FLEET BANK OF MASSACHUSETTS Good afternoon, Mr. Chairman, and Members of the Committee. My name is John Hamill, President of Fleet Bank of Massachusetts, and with me from Fleet Finance, Inc. ("Fleet Finance") are R. Harold Owens-Chief Operating Officer, John B. Stanforth, Senior Vice President-Finance, and Therese G. Franzen, Senior Corporate Counsel. We are pleased to represent Fleet Financial Group, Inc. ("Fleet") and Fleet Finance today in discussing allegations that residents of communities that lack access to traditional sources of credit have been targeted by unscrupulous brokers, lenders and home improvement contractors for loans with abusive terms and conditions. We would also like to address the role of the consumer finance industry in providing credit to these borrowers and the recent controversy surrounding Fleet Finance and its business in Georgia. 1. Introduction of Fleet Financial Group and Fleet Finance. a. Fleet Financial Group. Fleet, headquartered in Providence, Rhode Island, is the nation's 14th largest bank holding company with over $47 billion in assets . Fleet has 1,300 offices in 42 states, and employs over 27,000 people in its seven banks and five major nonbank financial services companies, including Fleet Finance, its consumer finance subsidiary. Fleet operates 7 banks in the Northeastern United States, with approximately 800 branches and $33 billion in deposits. Fleet banks serve their communities well, having consistently received "outstanding" or "satisfactory" ratings under the Community Reinvestment Act.¹ Fleet banks have provided over $1.6 billion in loans to low and moderate income neighborhoods in the communities in which they operate. Fleet's other nonbank subsidiaries provide conventional first mortgage banking services (Fleet Mortgage, the second largest servicer of mortgage loans in the nation, made over $19 billion in mortgage loans in 1992); student loan processing (AFSA is the largest third-party student loan servicer in the United States, charged with collecting over $2 billion in guaranteed student loans); trust and investment services (Fleet Investment Services has over $44 billion under management or in custody); and leasing/asset-based finance (Fleet Credit is the largest bank-owned asset-based lender/leasing company in the United States, with over $2 billion in outstanding loans to small and mid-sized businesses). b. Fleet Finance. Fleet Finance has a history of providing credit to those who cannot obtain credit from traditional sources, such as banks or credit unions. Fleet Finance began its business 57 years ago as “Southern Discount Company" during the great depression, as a small loan lender in rural Georgia. During the ensuing decades, the business expanded to provide small consumer loans in other southeastern states (Florida, North Carolina, South Carolina and Tennessee). In the 1960's and 70's, as the American consumers' appetite for larger personal loans increased, the consumer finance industry and Fleet Finance began to offer secured real estate loans. This type of loan provided more credit to the borrower, consistent with a lender's prudent credit standards . Many of Fleet Finance's early real estate secured loans resulted from Fleet Finance refinancing secured or unsecured small loans into real estate secured loans in order to provide additional credit to the related borrowers, usually at lower rates. Due to geographic restrictions on Fleet's ability to expand its banking franchise prior to adoption of interstate banking in 1985, Fleet sought to expand its presence into other geographic markets through nonbank acquisitions . One of Fleet's first nonbank acquisitions was the acquisition of Fleet Finance in 1973. Under Fleet's ownership, the operations of Fleet Finance continued to expand and, in 1983 , Fleet acquired Credico Industries, a subsidiary of U.S. Industries, which gave Fleet Finance a Mid-Atlantic and Northeast presence. In 1985, the consumer finance operations of several affiliates of Fleet were merged into Fleet Finance, giving it a Midwest presence . Until the late 1980's, Fleet Finance and Fleet's banks did not operate in any common states (except to a very limited extent in Rhode Island). Today, Fleet Finance has a limited presence in the six states in which Fleet has bank subsidiaries. ¹Additional information concerning Fleet's community reinvestment ratings and its associated lending activities are described on Exhibit 1. 333 As the scope of Fleet Finance's operations widened during the 1980's, the company's secured real estate portfolio grew. This growth was a result of various factors, including increased consumer demand for secured real estate loans as compared to higher-rate unsecured credit, the Tax Reform Act of 1986 (which eliminated personal interest deductions other than interest paid on home mortgage loans), increased real estate values (which—provided borrowers more equity in their homes against which they could borrow) and the attractiveness of real estate loans from a lender's viewpoint, i.e. , security with a more readily ascertainable value than loans secured by home furnishings or other items. Fleet Finance grew from a company with $413 million in outstanding real estate loans at December 31, 1985 to a company with $2.2 billion in outstanding (owned and serviced) real estate loans at December 31, 1992. Total loans grew from $863 million at December 31, 1985 to $2.6 billion at December 31, 1992. Today, Fleet Finance, headquartered in Atlanta, provides consumer finance services throughout Georgia and in 25 other states. Fleet Finance is now one of the largest consumer finance companies in Georgia (based on its aggregate principal amount of outstanding loans in Georgia). Fleet Finance owns or services approximately 20,000 real estate secured loans in Georgia and another 60,000 throughout the country. In addition, it has approximately 100,000 consumer loans (non-real estate loans) outstanding across the country. 2. A General Overview of The Consumer Finance Industry. To put in context the allegations which have been cited in the request for testimony and which have been leveled against Fleet Finance in the press and in various lawsuits filed against it, it is necessary to review the role played by the consumer finance industry in providing credit to deserving customers. The consumer finance industry, in which Fleet Finance is a participant, provides credit to millions of consumers across the nation, many of whom are low and moderate income borrowers who cannot obtain credit from traditional sources, such as banks or credit unions. As Fleet Finance's real estate lending business has developed into the primary focus of its business, so too has real estate lending become the dominant focus of the consumer finance industry. The total principal amount outstanding nationwide for what are now called "home equity" loans (both floating rate products and fixed rate products) was approximately $270 billion at June 30, 1992, increased from $108 billion at December 31, 1985. The credit providers in this broad market include banks, nonbanks, consumer finance companies and others.2 Fleet Finance competes in the consumer finance sector of this vast market with major national companies, such as Associates (a subsidiary of Ford Motor), AVCO Financial (a subsidiary of Textron), Chrysler First Financial (a subsidiary of Chrysler and scheduled to be acquired by NationsBank), Household International, Beneficial Corp., Transamerica, G.E. Capital, The Money Store and Old Stone Credit, the nonbank consumer finance subsidiaries of Bank of America, Norwest and NationsBank, and many other companies. This industry has grown tremendously over the last decade and currently has over 15,000 competitors. 3. The Role ofHome Equity Loans in Consumer Finance Transactions. Home equity loans made by Fleet Finance and other companies are typically used by consumers to reduce their monthly expenses by consolidating debts and stretching payments over a longer term. Longer terms and lower interest rates reduce a borrower's monthly payment, easing cash flow problems. In addition, home equity loans are used to finance home improvements, to acquire personal property, to pay educational, medical or other expenses or for other purposes. The growth of the consumer finance industry has been particularly beneficial for millions of low and moderate income borrowers. Many of these borrowers have credit problems that disqualify them for unsecured or secured bank credit, traditional credit cards or unsecured or secured small loans. Banks have been unable to pro2SMR Research Corporation reported as of June 30, 1992 home equity loan outstandings by type of company and by specific entity. See Exhibit 2. The first chart includes all loans outstanding for these entities, whether bank or non-bank. The second chart shows the outstandings by type of company, i.e. , finance company, finance company affiliated with a bank holding company, etc. 3SMR Research Corporation, Second Mortgage Home Equity Loans, 1991 (the "SMR 1991 Report"), at p. 23. Also see Note 2 above. For a description of the growth in the consumer finance business, see pages 6 et seq. of the SMR 1991 Report. Fleet Finance's underwriting criteria (see Exhibit 3 ) reflect variances from the underwriting criteria used by traditional first mortgage lenders. Fleet Finance's criteria are similar to those used by other lenders in the consumer finance industry. 334 vide credit to many of these types of borrowers due to regulatory restrictions resulting from concern over the funding of these riskier loans with insured deposits, regulatory accounting principles and the historic lack of a secondary market to provide liquidity for these loans. Consumer finance companies, however, because they are free in many respects from regulatory restrictions (because they do not fund their operations with deposits), traditionally have been able to employ more liberal underwriting criteria which enable them to lend to lower income borrowers and borrowers with credit problems. An example of the potential benefit to low and moderate income borrowers of the typical consumer finance company's underwriting criteria is the use of so-called "front end" and "back end" ratios. For example, on an FHA mortgage loan, only 29 percent (the "front end" ratio) of the obligor's income is available for payments of principal and interest on the mortgage loan and taxes and insurance on the home and 41 percent (the "back end" ratio) is available for total installment debt payments (including those associated with the loan). If a borrower does not meet these ratios, the loan application is generally denied. A consumer finance company focuses only on the "back end" ratio, permitting up to a 45-50 percent debt-to-income ratio for all installment debt. This less restrictive guideline can provide a customer with the flexibility to enable him to obtain and carry more housing-related debt and more total debt for personal use. The consumer finance industry provides a critical source of credit for low and moderate income borrowers through secured real estate lending, enabling these borrowers to overcome their credit problems and borrow money when they need it without having to comply with traditional, restrictive bank lending guidelines. Moreover, home equity loans as a source of credit reach far beyond restrictive conventional mortgage loan programs, which generally provide credit only for a purchase or refinance of real estate, rather than for cash for personal use. 4. Why Costs to Borrowers for Home Equity Loans Are Higher Than Costs for Conventional Mortgage Loans. Consumer finance company interest rates on home equity loans are generally higher than interest rates on traditional first mortgage loans or bank quality second mortgage loans . These higher rates result generally from ( 1) higher delinquency rates and charge-offs associated with consumer finance company home equity loans, (2) higher costs of originating consumer finance company home equity loans, (3) higher costs of servicing consumer finance company home equity loans, and (4) higher funding costs associated with consumer finance companies. Consumer finance company delinquencies are traditionally higher than first mortgage loans or "bankable" second mortgage loans. These delinquencies are coupled with higher loan charge-offs. The industry charges higher interest rates to offset the effect of the higher charge-offs and delinquency rates associated with consumer finance home equity loans as opposed to traditional bank first mortgage loans and "bankable" second mortgage loans. The costs of originating and servicing a home equity loan are much higher than those incurred in connection with traditional first mortgage loans because such first mortgage loans generally have much higher balances. There is no appreciable difference in the cost of originating a $ 100,000 first mortgage loan and a $20,000 home equity loan. Both loans require substantially the same documentation and analysis. However, an origination cost of 2 percent on the first mortgage loan ($2,000) becomes 10 percent on the $20,000 home equity loan. Likewise, the monthly cost of servicing a home equity loan is higher than the monthly cost of servicing a first mortgage loan, relative to their respective balances. In addition to the standard servicing costs, the type of credit risk reflected in a consumer finance company's home equity loans is more costly to service than first mortgage loans or bankable second mortgage loans due to the more labor intensive work required to avoid delinquencies, to work with delinquent borrowers to avoid foreclosure, to collect delinquent loans and to restructure or modify loans as required by customer demands or needs. These additional costs not incurred with respect to traditional first mortgage loans or bankable second mortgage loans result in consumer finance company borrowers paying increased interest rates in order for the consumer finance company to earn a fair return. The funding of a consumer finance company is more costly than the funding of a bank. Banks raise their funds through deposits at government guaranteed rates; Fleet Finance and other consumer finance companies raise funds at market rates dictated by their credit ratings, or from banks or insurance companies who lend to the consumer finance industry (and who charge rates in excess of deposit rates). "See 1992 SMR Report p. 23 and Notes 12 and 13 below. 335 Consumer finance companies also do not enjoy the leverage of banks; their required equity is more than double that of a bank, and thus, the funding cost in terms of the required returns on equity is much higher. Finally, the relative illiquidity of second mortgages compared to conventional first mortgages has caused consumer finance companies to maintain larger balance sheets, resulting in larger-equity requirements and greater sensitivity to asset/liability management risks due to prepayments and interest rate changes. Fleet Finance and other similar companies, although slightly more profitable on a comparative basis (i.e. return on assets, return on equity) than a bank, are not "wildly" profitable as the press would like this panel to believe. The companies price their products commensurate with the risk inherent in their customer base, and a fair return is garnered. The chart attached as Exhibit 6 compares Fleet Finance's interest rates to the rates of its Georgia competitors during 1992. These rates, which ranged from 9.99 percent to 17.50 percent throughout 1992, compare to credit card rates as high as 21 percent and to small loan rates as high as 30 percent. The interest rates charged on consumer finance home equity loans clearly are higher than those charged on first mortgage loans or bank quality second mortgage loans, but in the end provide a cheaper alternative to other unsecured debt, such as credit card or small loan debt. 5. Fleet Finance's Development of Business: Issues and Recent Changes. As the consumer finance industry developed and changed its focus to secured real estate lending, Fleet Finance changed its focus to this type of lending along with it. During the 1980's Fleet Finance decided to expand its real estate lending business through the acquisition of loans which were originated by other correspondent lenders. In Georgia, as well as nationwide, it is a common and established practice for banks and finance companies to purchase loans originated by third parties. Fleet Finance has acquired loans from over 300 correspondent lenders nationwide. Fleet Finance purchased loans from correspondent lenders, generally on a loanby-loan basis, often preapproving the loans prior to purchase. The correspondent lenders would submit to Fleet Finance a loan package consisting of a credit application, credit history, debt-to-income and other relevant ratios, and estimated property value. Fleet Finance would perform an analysis of this preliminary package, and make its basic underwriting decision. Unlike some other companies, Fleet Finance's policy required it to underwrite each loan purchased from its correspondents, not just a sample. Fleet Finance rejected substantial numbers of loans for various reasons. Approval rates for preapproved loans were as high as 65-70 percent for some lenders. After establishing that the loan met its lending criteria, Fleet Finance would give conditional approval for the purchase of the loan. After closing and funding, and subject to the borrower and correspondent lender having complied with all conditions to approval, the loan would be purchased by Fleet Finance. Fleet Finance also acquires loans in bulk packages from correspondents and others (including the RTC and other large lenders). Underwriting procedures for a bulk purchase may vary and may consist of a loan-by-loan review or a review of a sample of the loans to be purchased. In 1989, Fleet Finance tightened its lending requirements by discontinuing the origination or purchase of loans secured by undeveloped land and, discontinuing, in most cases, the purchase of loans made for the purpose of home improvements directly from the originator. Changes, such as discontinuing the purchase of home improvement loans, were made by Fleet Finance in response to changes in the economy as well as difficulties in policing the practices of home improvement companies. Because of federal and state laws regarding home improvement contracts, Fleet Finance was ultimately responsible for repairing incomplete or defective home improvements in connection with loans it had purchased. In 1988, Fleet Finance was purchasing approximately 85-90 percent of its loans from correspondent lenders. For various reasons, but principally to reduce its dependence on these purchased loans, Fleet Finance made a strategic decision to more *Correspondent lender networks are the standard means of doing business in the first mortgage industry. For example, Fleet Mortgage acquires loans from over 800 correspondents. FNMA, GNMA, FHLMC and other mortgage conduits effectively acquire all of their production through a correspondent network. In this regard, the consumer finance industry is not much different, as many ofthe larger lenders acquire much of their production through such networks. See 1991 SMR Report (at p. 74), "The Rise of Wholesale Channels" regarding the growth of the wholesale market for second mortgages (attached as Exhibit 4). "Of these pre-approved loans, only approximately one third ultimately closed and were purchased by Fleet Finance due to fall-out foil various reasons, including failure to meet closing conditions or the customer obtaining credit from another source. 336 rapidly develop its branch structure by upgrading personnel and systems to enable its branches to make and service more home equity loans. Branches achieved growth through direct marketing and referrals from various parties. From 1988 to 1992, the mix of loans originated/purchased changed from approximately 85-90 percent purchased/5-10 percent originated to approximately 50 percent purchased/50 percent originated. Beginning in 1990, the branch origination focus was enhanced by the consolidation of servicing of all purchased loans into regional service centers, which left branches with a greater capacity to originate and service their own loans. Fleet Finance decided to entirely phase out the purchase of loans from correspondent lenders, effective December 31 , 1992. The decision to eliminate the purchase of loans from third party lenders was made with the goal of providing direct contact between Fleet Finance and its borrowers prior to the loan being closed. The change was also made in response to criticisms concerning the allegedly excessive rates and fees charged on loans sold to it by third party lenders and for other alleged improper practices of these lenders . To eliminate this criticism, Fleet Finance decided to control each loan beginning width the application and proceeding through the negotiation of interest rates and the terms ofthe loan and the loan closing. In addition, Fleet Finance decided in 1992 to discontinue making loans to higher risk borrowers (identified in the industry as Class 4 or Class D borrowers). 6. The Georgia Lawsuits, Alleged Activities of Fleet Finance in Georgia and Fleet Finance's 10-Point Initiative. a. Background. Before discussing the specifics of the lawsuits against Fleet Finance in Georgia and the allegations in the press concerning Fleet Finance, it is necessary to describe the backdrop against which these lawsuits and allegations have taken place. In Georgia, unlike in the vast majority of states, third party loan brokers and lenders and home improvement contractors are completely unregulated, and interest rates and points are virtually unrestricted. In addition, Georgia has an aggressive plaintiffs' class-action bar, which welcomed the opportunity to bring law. suits that they could couple with a media campaign to extract favorable settlements from Fleet. Another reason Fleet has been the subject of attack is due to its high profile selection as the acquiror of Bank of New England ("BNE"). As a regulated bank holding company with obligations under the Community Reinvestment Act, Fleet was and is a particularly attractive target for community activists. A challenge against Fleet's ' acquisition of BNE was made by the Union Neighborhood Assistance Corp. ("UNAC") and other community groups. Bruce Marks, in the presence of representatives of the Federal Reserve Bank of Boston, met with Fleet officials, but Fleet did not agree to his demand that $20 million be placed under UNAC's control for a housing fund. Fleet made other contributions to help solve the so-called " second mortgage scandal" in Boston, however it made its contributions through a broad array of community groups (and not UNAC). Since that time the volume of allegations made in the press have largely been the result of an orchestrated attack against Fleet by UNAC with the help of the plaintiffs' attorneys. This attack has been made without regard to the facts and is Mr. Marks' attempt to make good on his promise to have the story covered in the national press, whether or not it is based on the truth (a promise he had made in his meeting with Fleet). b. Georgia's Regulatory Framework. Georgia enacted legislation in 1983 to remove its restrictive limitations on interest rate charges and adopted a free-market approach. Prior to the change, Georgia had capped mortgage rates making it impossible for Georgia residents, particularly low to moderate income borrowers, to obtain loans in the high interest rate environment of the early 1980's . To remedy this, legislation was passed which lifted the mortgage interest rate limitations, and credit immediately began to flow into the state. The Georgia legislature, however, may not have given adequate consideration to the fact that Georgia, unlike most other states, does not regulate brokers and lenders. In comparison, Fleet Finance makes real estate secured loans in 26 states, and is required to be licensed in 23 of these states. Many of these states regulate the amount of compensation which can be paid to a broker or lender, but Georgia does not. Georgia also does not regulate home improvement contractors. c. The Georgia Lawsuits. Despite the fact that the alleged injuries complained of by the plaintiffs in the Georgia class action lawsuits pending against Fleet Finance were caused by the parties from whom Fleet Finance purchased the plaintiffs' loans or by home improvement contractors who contracted with the plaintiffs prior to Fleet Finance's purchase of the plaintiffs' loans, purported class action lawsuits Fleet supports the licensing and regulation of brokers and lenders. Such legislation is now pending in Georgia. 337 have been brought against Fleet Finance, beginning in 1991, alleging violations of Georgia's criminal usury laws, as well as fraud, conspiracy, federal and state RICO claims and Truth-in- Lending violations.⁹ The usury charges against Fleet Finance and other companies in Georgia, which charges are, for the most part, the basis for these lawsuits, are premised upon a very radical interpretation of the Georgia criminal usury statute. The interpretation postures that points and other up-front fees charged on a loan should be allocated completely-to the first month to calculate whether Georgia's law prohibiting interest charges above 5 percent per month has been violated. This theory directly contradicts the concept of "spreading the points over the term of the loan, which is the standard practice in Georgia ( as set forth in a 1990 Georgia Supreme Court opinion), as well as the standard practice under Truth-in-Lending regulations, generally accepted accounting principles, regulatory accounting principles, the Internal Revenue Code and the law of all other states. Oral arguments were heard on January 19, 1993 by the Georgia Supreme Court in the plaintiffs' lead case (a similar case was dismissed in federal court and the appeal is stayed pending the state court's decision). Fleet Finance's legal position with regard to the usury calculation is supported by the banking industry, and numerous lending institutions and trade associations have filed amicus briefs with the court supporting this position, including Trust Company of Georgia, NationsBank, Wachovia, Citizens Trust Bank (a minority-owned institution), AVCO, Transamerica, Norwest, the National Second Mortgage Association, FNMA, and the Georgia Bankers Association. A decision on the issue is expected in two to six months. d. Specific Allegations About Fleet Finance. Various specific allegations have surfaced in the press regarding the consumer finance industry and Fleet Finance. While Fleet Finance cannot speak for the industry, it would like to address the following specific charges that have been made against it: ALLEGATION: Fleet Finance has amassed a pool of home equity loans made at exorbitant interest rates and with excessive finance charges. The facts are straightforward: Fleet Finance's rates range from lower rates for better credit borrowers to higher rates for borrowers with credit problems. While certain borrowers, due to their credit circumstances, are required to pay higher rates than others, very few Fleet Finance borrowers have loans of the type cited by the activists and the media. The facts are: • Fleet Finance's portfolio of home equity loans in Georgia has a weighted average note rate of approximately 14.8 percent. Moreover, it has a weighted average annual percent age rate including all lender points and all other prepaid finance charges ("APR") of approximately 15.9 percent. • Approximately 98 percent of the principal balance of Fleet Finance's Georgia loans have interest rates below 21 percent; 83 percent have interest rates below 18 percent. • Approximately 89 percent of the principal balance of Fleet Finance's Georgia loans have an APR below 21 percent; 69 percent have an APR below 18 percent. • Approximately 41 percent of the principal balance of Fleet Finance's Georgia loans by principal balance have 0 lender points; 63 percent have less than 5 lender points; 88 percent have less than 10 lender points; 98 percent have less than 11 lender points. • Points charged were financed by the lender and repaid over the life of the loan (contrary to first mortgage loans where payment of points must be made at closing). • Approximately 79 percent of the principal balance of Fleet Finance's Georgia loans had 0 broker points; 90 percent had 5 or less broker points; and 98 percent had 10 or less broker points. • Fleet Finance competes with many other lenders. The competition would bring any lender into line with other lenders in the industry. In fact, rates on loans owned by Fleet Finance are comparable to those charged in Georgia¹º and throughout the country by other lenders. • The effect of financed points during the term of a loan on the annual percentage rate is not as dramatic as one might expect.¹¹ Despite the above facts, Fleet Finance has decided to eliminate any possibility of this charge reoccurring in the future by taking the extraordinary step of limiting brokers to a total of 5 points and placing an 18 percent interest rate cap on its loans A summary of the litigation is set forth as Exhibit 5. 10 See Exhibit 6 for a comparison of rates charged by competitors in Georgia. 11 See chart on Exhibit 7 for a comparison of effective annual percentage rates with various numbers ofpoints. 338 in Georgia and nationwide. Many states specifically permit higher levels of points (such as Florida which permits 10 points) but Fleet Finance chose this lower level to deflect the above criticisms, whether or not they have merit. ALLEGATION: Fleet Finance engages in "home equity stripping"; Fleet Finance makes huge profits on the sale of foreclosed properties. Fleet has destabilized communities through its foreclosures. This allegation is false. Fleet Finance loses money on foreclosures; eliminating foreclosures would make the company more profitable. The number of foreclosures in Georgia clearly establishes that Fleet Finance is not in this business, and could not be responsible for destabilizing neighborhoods. The facts are: • In Georgia, Fleet Finance lost more than $5.4 million on foreclosures in 1991 and more than $8 million in 1992. Nationwide, Fleet Finance lost $18.6 million and $24.6 million on foreclosures in 1991 and 1992, respectively. The weighted average combined loan-to-value ratio of Fleet Finance's Georgia portfolio is approximately 70 percent. Fleet Finance's loan to value ratios are based on appraised values under the current market conditions. • Approximately 79 percent of the principal balance of Fleet Finance's Georgia loans have combined loan -to-value ratios in excess of 60 percent; 25 percent have combined loan-to-value ratios above 80 percent; 50 percent have combined loan-tovalue ratios between 60 percent and 80 percent. • Fleet Finance foreclosed on approximately 530 loans in Georgia during each of 1991 and 1992. • Because Georgia has been its headquarters for 57 years, Fleet Finance is the largest consumer finance company second mortgage lender in Georgia, therefore, gross numbers of foreclosures compared to other smaller companies are misleading. • Fleet Finance's policy is to not commence foreclosure until a loan is at least 90 days delinquent. During the period of delinquency, Fleet Finance works with the borrower in an attempt to keep the borrower in their home. ALLEGATION: Fleet Finance made loans without regard to whether the borrower had the ability to repay the loan. Because Fleet Finance loses money on foreclosures, it would not be profitable for Fleet Finance to lend money to borrowers who lack the ability to repay their loans. The ability of the borrower to repay the loan is established by requiring sufficient cash flow. The facts are: • Fleet Finance's underwriting criteria require (and have always required) a debtto-income ratio of less than 50 percent, as well as verification of income and verification of employment. • The weighted average debt-to-income ratio of Fleet Finance's borrowers in Georgia (calculated by including all debt at origination, including the Fleet Finance loan) was approximately 36 percent. • Approximately 62 percent of Fleet Finance's Georgia borrowers had debt-to-income ratios of less than 40 percent; 78 percent had debt-to-income ratios of less than 45 percent and 90 percent had debt-to-income ratios under 50 percent. • Fleet Finance's delinquency rates are comparable to those found generally in the industry, 12 and, while such rates are higher than first mortgage loans, they are not substantially higher.13 ALLEGATION : Fleet controls the correspondent lenders and brokers in a conspiracy to steal people's equity in their homes. Fleet Finance did business with over 300 third- party lenders nationwide. A wholesale production network is common in the production of mortgage loads. This type of wholesale network has become the backbone of much of the consumer finance industry.14 Fleet Finance qualified its lenders through an internal review and ap12 See Exhibit 8 for Fleet Finance's delinquency statistics compared to other industry participants. 13 On November 25, 1992, the Mortgage Bankers Association issued its report on nationwide first mortgage delinquencies and foreclosures at June 30, 1992. Residential first mortgage loans in foreclosure were 1.04 percent of total dollar amount of loans outstanding, while 90 day delinquencies on first mortgage loans were .78 percent of the outstanding balance. At June 30, 1992 and September 30, 1992, 1.98 percent and 2.04 percent, respectively, of the dollar amount outstanding of Fleet Finance's total portfolio of loans owned and serviced were in the 91 day or more delinquency category, which category includes loans in foreclosure (i.e., these figures compare to 1.82 percent of nationwide first mortgage delinquencies and foreclosures as of June 30, 1992). 14 See note 6 above regarding the growth of the wholesale component of the consumer finance industry. 339 proval process. More importantly, Fleet Finance's policy was to underwrite the loans it purchased, not to rely on the credit analysis of third parties. The facts are: • Fleet Finance was independent of the correspondent lenders and brokers; it did not share employees, directors or officers. • Fleet Finance preapproved loans, but this procedure is standard in a correspondent lender program. All transactions were conducted on an arms-length basis. • Fleet Finance terminated lenders who did not meet Fleet Finance's standards. Most of the allegations against Fleet Finance have centered on purchased loans. Fleet Finance decided to terminate all individual third-party loan purchases as of December 31, 1992 as part of its 10 Point Initiative. Fleet Finance believes the purchase of loans is still a legitimate method of doing business, but has decided to avoid any possible repetition of allegations concerning purchased loans. ALLEGATION: Fleet and other bank holding companies engaged in a tactic of removing their banking operations from low and moderate income neighborhoods to allow their second mortgage companies to prey on borrowers in those neighborhoods. This allegation against Fleet has no merit because Fleet is prohibited by law from owning a bank in Georgia. Fleet did not own a bank in Massachusetts until 1991 (when it purchased BNE). Thus, Fleet could not have been engaged in this alleged practice. Many other bank holding companies who operate nationwide would face the same sets of laws restricting their banking presence . ALLEGATION: Fleet Finance, through third party lenders, targeted minority neighborhoods and charged higher rates to blacks than whites. Fleet Finance does not generally know the race of a borrower prior to its commitment to acquire a loan. Fleet Finance set its rates based on credit statistics, not on race. In fact, for over 35 percent of Fleet Finance's loans, it is impossible to ascertain the race of the borrower from the files. ALLEGATION: Fleet Finance is wildly profitable due to the above alleged practices and dominates Fleet's profitability. This is simply not true. Fleet Finance's returns on equity and return on assets are higher than Fleet's banks, but not significantly higher. A consumer finance company has greater returns than a bank due to the risk inherent in a consumer finance company's portfolio; there is a greater risk that credit problems could significantly affect Fleet Finance's profits. The contribution of Fleet Finance to the earnings of Fleet is historically 8-10 percent. The results cited by our critics for 1990 and 1991 fail to take into account the credit problems in Fleet's New England banks caused by the recession in the Northeast.15 Fleet Finance does not dominate Fleet's earnings. e. Fleet Finance's 10 Point Initiative. Fleet Finance believes that neither the above charges, nor other isolated charges made by the press, have merit . To illustrate its good faith, to address any perceived abuses and to benefit its customers, Fleet Finance adopted its 10 Point Initiative.16 This initiative is intended to aid those customers whose loans are deemed burdensome without regard to the merits of the loan involved. It is not an admission of culpability by Fleet Finance as our critics might allege; it is an important customer relations program with the goal of reminding our customers of the fact that Fleet Finance is always ready to responsibly address their problems. This Initiative was a responsible act by a responsible company to address an issue in a responsible manner. The initiative provides up to $38 million in various benefits to borrowers, including interest rate relief, a foreclosure moratorium, home improvement repairs, grants for revitalization of impacted neighborhoods, along with other benefits. The Initiative also confirmed Fleet Finance's policy to discontinue purchases of home improvement loans and loans from third party lenders generally. Fleet Finance also has made a total of $8 million available to impacted neighborhoods for reinvestment. Over 750 borrowers have already been approved for relief under the Initiative, and Fleet Finance expects to continue to provide the Initiative despite the efforts by the plaintiffs' lawyers who have sought to enjoin Fleet from pursuing the Initiative. The purpose behind such a move by the lawyers is not concern for the best interests of the borrowers, especially in light of the fact that no waiver of the borrowers' legal rights is required to obtain the relief. The 10 Point Initiative demonstrates Fleet 15 Exhibit 9 shows the earnings of Fleet Finance over the past 12 years, compared to those of Fleet. Gains on securitizations also increased Fleet Finance's 1990 and 1991 earnings, but represent the present value of future earnings which will not be earned in subsequent years. 10The 10-Point Initiative is attached as Exhibit 10. 340 abuse or complaint, Finance's willingness to work with, and resolve any individual 17 whether allegedly caused by Fleet Finance or otherwise.1 7. Recommendations of Fleet Finance. There are a number of steps that could be taken at the state and local, and perhaps federal, levels to address those complaints, including: a. Regulation of Lenders, Brokers and Home Improvement Contractors. The regu lation of second mortgage market participants, including lenders, loan brokers and home improvement contractors, appears to be primarily a state matter. Fleet Finance welcomes reasonable regulation as a way to ensure the integrity of all participants in the industry. Fleet Finance is currently regulated in 23 states. Current federal regulations include the Real Estate Settlement Procedures Act ("RESPA"), which prior to November 1992 covered only purchase money first mortgage loans and now covers all mortgage loans, and the Truth-in-Lending Act "TILA") (as well as state consumer statutes) which covers home equity loans and provides a federal scheme for disclosure of their true interest rate to consumers. Amendments to the TILA could be enacted requiring stronger home improvement contract disclosures, such as escrow requirements (including standard provisions) and disclosure of whether the contractor is an independent entity or related to the lender/broker or other party. Additional statements could be required to disclose the risks to the borrowers of failing to pay a secured home improvement loan (i.e., foreclosure). With respect to brokers, additional disclosure requirements could be fashioned under TILA for broker fees (lender fees are already included). Those fees could even be included in the calculation of prepaid finance charges as an additional cost of credit (despite the fact that the broker is working for the borrower). b. Role of Government Sponsored Entities ("GSES") in Home Equity Lending. The Federal National Mortgage Association ("FNMA"), Government National Mortgage Association ("GNMA"), Federal Home Loan Mortgage Corporation ("FHLMC") and other similar agencies could take a more active role in helping the private sector increase credit availability to finance company borrowers. Home equity lenders would benefit from additional liquidity for home equity loans. Securitization provides some relief, but only larger companies have the resources to engage in this activity. Increasing the liquidity of these loans should result in lower rates for borrowers . The current GSE first mortgage program could be expanded to help guarantee payments on nonconforming loans and junior priority loans . This step would encourage more capital to enter the market, which should ultimately lead to better pricing (and less cost to borrowers). The resulting increase in liquidity would enable fenders to use their capital more efficiently to fund servicing and collection operations, in addition to making loans, thereby permitting more leveraging of a finite amount of capital. In addition, completion certificates could be required from the home improvement contractors to the GSE and the lender, regarding the value of home improvement work and its completion (as opposed to the borrower certifying completion ). The GSE and the lender would then be in a better position to exert pressure on the contractors if their work was not done properly. c. Consumer Education. Another way to get the federal and state governments involved would be a nationwide education program. The lack of public education regarding consumer credit and the lack of awareness of credit-related issues on the part of consumers is problematic. In many cases consumers are said to have little knowledge about the available sources of credit and how consumer debt burdens can have an adverse impact on a person's credit rating and standard of living. In particular, borrowers who enter into debt consolidation arrangements have created situations where they have a very difficult time meeting their restructured ob17An example of how Fleet Finance's customers have been used by lawyers who purport to represent them can be seen in the case of Mr. James Hogan who recently testified at a House Subcommittee hearing. Mr. Hogan's attorneys (Legal Aid Society [ Bill Brennan ]) have refused to allow Mr. Hogan to participate in the Initiative. Mr. Hogan's home was foreclosed on when he could no longer make his payments , partially because he lost his job and was incarcerated. Fleet Finance has offered Mr. Hogan every chance to work out a solution, dating back to December 1991. Fleet Finance's efforts included working with his social service case worker after his release from jail. In addition , Fleet Finance offered Mr. Hogan, in October 1992 , an opportunity to participate in the 10 Point Initiative, but Legal Aid refused to let him do so. Under the 10 Point Initiative he would not only have received his house back, but a loan at approximately 9 percent interest. We have made these circumstances known to Representative Kennedy and have submitted a written offer to his counsel to resolve this situation with a 9 percent loan for approximately $25,000 (his loan balance was approximately $32,000 ). Legal Aid has requested that Fleet Finance deed the house back to Mr. Hogan without consideration. 341 ligations. Recent problems associated with persons selling debt consolidation feebased services have been reported. Some states have already moved to license this activity, but helping educate consumers will give them the information necessary to reduce their borrowing costs. d. Rate Regulation. Rate regulation which would specify a maximum cost of credit has been proposed in Georgia. Some other states already have such rate and point regulation. Federal or state regulation of maximum rates and points may result in credit allocation away from some credit needy persons and should be considered carefully. Mr. Chairman and Members ofthe Committee, Fleet and Fleet Finance are proud of their long and distinguished record of providing a wide range of services to the American consumer. While Fleet Finance stands ready to discuss any individual borrower's complaint to reach an appropriate resolution, Fleet believes that your Committee can perform a useful and important service by focusing on the critical role that a well-run, and properly regulated consumer finance company can play in providing credit to low and moderate income consumers, by identifying those areas of the consumer finance industry where state or federal action may be needed to correct problems and by making recommendations regarding how the regulation of the products and services offered by the industry can be improved. Thank you, and we look forward to answering any questions you and the Members ofthe Committee may have. 342 EXHIBIT INDEX Exhibit 1 Fleet's community reinvestment ratings , together with information concerning associated lending activities . Exhibit 2 ( a ) SMR Research Corporation ( " SMR " ) , The Top 25 Second Mortgage Lenders , 6/30/92 . (b) SMR , The Second Mortgage Market By Institutional Type of Player , 6/30/92 . Exhibit 3 Fleet Underwriting Criteria . Exhibit 4 Excerpt from SMR 1991 study , " The Rise of Wholesale Channels " at p . 74 . Exhibit 5 Summary of the Georgia litigation . Exhibit 6 Chart comparing Fleet Finance's rates to competitors of Fleet Finance . Exhibit 7 Chart showing effects of various levels of points on a 15 -year loan . Exhibit 8 Delinquency statistics . Exhibit 9 Fleet Finance Earnings Comparison . Exhibit 10 10- Point Initiative of Fleet Finance . 343 EXHIBIT 1 FLEET FINANCIAL GROUP LOW AND MODERATE INCOME COMMUNITY LENDING PROGRAMS Fleet Financial Group ( Fleet ) has been very active in community lending and has had a comprehensive and effective Community Reinvestment ( CRA) compliance program in place for a number of years. In fact , Fleet's banks all received either " outstanding" or "satisfactory" CRA ratings in their most recent examinations . However, in response to discouraging industry-wide statistics in 1991 and 1992 showing that racial disparities exist in mortgage application approval rates , Fleet has stepped up its efforts and is undertaking an aggressive effort to make its CRA and HMDA compliance programs more effective and increase mortgage loans to low to moderate income and minority borrowers . Fleet established a corporate HMDA/CRA task force under the direction of Executive Vice President Jia Murphy . The task force's mission was to research and study the facts concerning the disparities in approval rates by race , resolve HMDA/CRA systems and reporting issues , and evaluate Fleet's products in Beeting the needs of low to moderate income and minority communities . During the first half of 1992 , Fleet compliance personnel , along with outside HMDA /CRA compliance consultants , assessed HMDA/ fair lending programs at each Fleet bank and mortgage company . Although the results of this unprecedented review did not reveal any discrimination against applicants , it did show that HMDA data collection and reporting systems needed improvement , fair lending compliance management processes needed strengthening , and increased training was needed overall in these areas . As a result , a new " Centrax" system ( a computer-based data processing system ) was purchased which will improve data processing and tracking and timely management reporting . After discussions with local community groups to solicit their suggestions , Fleet took action to improve existing bank products to be more responsive to community needs , particularly in low income and minority urban areas . For instance , flexible first mortgage products for low to moderate income borrowers are now being aggressively marketed throughout all Fleet banks and mortgage companies . ע See attached . ບ Compiled and released by the Federal Reserve Board pursuant to the Home Mortgage Disclosure Act ( HMDA ) . 344 In addition , Fleet now has dozens of affordable housing programs in place throughout its system, and has improved its CRA efforts as well . Here is a summary of some of the major affordable housing and CRA programs in place at our banks and mortgage subsidiaries : 1. Rhode Island Jump Start Program: A innovative program called " Jump Start " was initiated on January 1 , 1992 to provide home ownership to low to moderate income families . Fleet's Rhode Island bank joined with the Rhode Island Housing and Mortgage Finance Corporation ( RIHMFC) and Commonwealth Mortgage Assurance Company to provide $ 10 million in low interest , no down payment financing for first time home buyers with income of no more than $23,000 per year . To date , over $ 4 million has been booked under this program (see attached press release) . Lease to Buy Program : Another program, done in conjunction with RIHMFC provides financing to low to moderate income Rhode Islanders to purchase a first home through a unique two-year lease purchase agreement. Over $3 million has been committed to this program (see attached press release) . Line-of-Credit Program : A program providing a $ 1 million restoring line - of - credit , priced at 2 percent over Fleet's passbook rate , was initiated to provide construction and renovation financing to non -profit companies to increase affordable housing stock . Over $1.7 million has been used to date. 2. Massachusetts Community Investment Lending Program On June 27 , 1991 , shortly after it acquired control over the banking subsidiaries of the former Bank of New England from the FDIC , Fleet initiated a $ 111 million community lending investment program for low and moderate income neighborhoods and communities in Massachusetts as part of a broader program designed to pump more than $ 500 million in new capital into the New England economy . This included an $ 11 million mortgage assistance program to help homeowners with burdensome mortgage loans ( see attached press release ) . 345 The plan, which has been very successful , will create over 1,750 affordable houses in Boston and across the state. It will also channel over $ 7 million to help minority-owned and other small businesses . 3. New York (New York City/Long Island) End Loan Financing Over the past five years , Fleet has made a concerted effort to become a leader in New York City in providing affordable housing and finance . Through Fleet Mortgage , it provided approximately $ 370 million in financing for the end loan financing of approximately 4,800 units of new 1-4 family housing in Brooklyn , Queens , the Bronx and Manhattan . This included end loan financing for 2,200 units of Nehemiah housing in Brooklyn by a coalition of churches and synagogues . Construction Lending Program Beginning in 1991 , Fleet's New York City bank began developing an active construction lending program for affordable housing by working with the New York City Partnership , New York State and New York City housing agencies , and various for-profit and non-profit developers and sponsors. In 1992 , $ 40 million in loans were booked, and as much as $ 100 million may be booked in 1993 . New York Mortgage Coalition On January 29 , 1993 , a two-year commitment was given to the New York Mortgage Coalition for $50 thousand a year for administrative costs with the understanding that Fleet will make approximately $ 5 million in loans each year. The program also include " second look " loan restructuring and credit counseling . Micro Loan Program A pilot "micro " loan program was initiated in the minority communities of Hempstead and Glen Cove , Long Island , with an anticipated commitment of $ 150 million to each, plus administrative support . Other programs in 1992 include: $5 million in co- funding for the start -up of a small business development center at Pace University in 3 · 346 Harlem ; a $10 million grant for neighborhood housing services . New York (Upstate) Portfolio Lending Fleet Bank of New York , in conjunction with the Neighborhood Housing Services , developed a new portfolio mortgage product targeted to low to moderate income populations living in distressed areas throughout Upstate New York . A partnership of 32 community organizations participate with the Bank to provide credit and homeownership counseling and assist in collecting potentially delinquent payments . A commitment of $ 12 million has been allocated . "Second Look" Program In February 1992 , the Bank implemented a " second look" program to ensure that fair lending practices are consistently in place . The " second look" program entails a second review of minority HMDA related loans by a senior consumer officer before the credit is denied to a minority applicant . Under this initiative , the Bank considers all options or restructuring opportunities through the use of more flexible underwriting guidelines to facilitate mortgage applicants . Targeted Advertising / Community Diversification In 1991 , Fleet Bank increased its emphasis on marketing which is targeted to minority communities . New ads , utilization of minority models , advertising in minority publications and the development of poster ads to reach our communities through branch and neighborhood networks have been initiated . Additionally , product brochures have been published in Spanish . Fleet Bank convened focus groups in Albany and Rochester in an effort to learn from minorities how best to serve minority consumers . Workforce Diversification / Outreach A full -time employee has been assigned to recruit and develop minority employees . During 1992 , Fleet Bank contacted approximately 210 organizations to determine ongoing credit needs ( with primary emphasis on affordable housing ) through the Bank's Direct CRA Calling Program . 347 Connecticut HART/Frog Hollow First Time Home Buyers Program In August 1990 , Fleet became a pioneer participant in this Hartford program by making a $1,000,000 commitment . This program is aimed at low/moderate income buyers in Hartford . Southend Institutions Neighborhood Alliance This is a $ 1,000,000 commitment for home mortgages in Hartford. New Britain Neighborhood Preservation Program This program is designed to aid homeowners for home improvements with low interest loans in collaboration with the City of New Britain . Fleet Bank has been involved with this program for 19 years . The total current commitment of the banks is $ 600,000 , with Fleet's share at $ 85,000 . Fleet Banker's Pool with Neighborhood Housing Services of New Britain These funds are used for the acquisition and renovation of residential properties with low rates and flexible terms . There is a $ 1,500,000 total bank commitment with Fleet's share at $215,000 . Thomas Valley Council for Community Action Through its Housing Advisory Committee , TVCCA is involved with housing projects in New London county . Childhood development , nutrition and neighborhood services are also areas of involvement . Fleet Bank is represented on the Finance Committee . Broad Park Development -- Hartford Fleet financed Jefferson - Seymour , an affordable housing project , in Hartford . Fairfield 2000 House Corporation ( F2HC) Fleet Bank has committed to a Fairfield County project consisting of 16 homes which are currently owned by the U.S. Army and which will be sold to low/moderate income households . Fleet Bank is represented on the Board of Directors . - 5 70-832 0 - 93 - 12 348 The Affordable Housing Funds for Connecticut This $5 million tax credit fund provides low/moderate income families with affordable housing throughout the state . It has developed 281 units of affordable housing and 7 retail stores in four years . Among its projects are Hartford's Sigourney News and Bridgeport's East Main . Fleet Bank is represented on the Board of Directors . New Haven Infill Prograz In collaboration with the City of New Haven , Fleet Bank has committed $ 1,000,000 to provide home buyers with mortgages for homes constructed on vacant lots in the city . Fleet Bank, with Legislative leaders , created the State Home Mortgage Task Force , made up of community leaders , public officials , mortgage lenders and banks . From this group came several home mortgage initiatives : A state law that permits interest in real estate escrow funds to be used for private mortgage insurance . The Connecticut Alliance of Homeownership Opportunities was then formed to purchase these loans. $16 million was committed for this purpose by Hartford insurance companies . A Review Committee has been created to monitor minority mortgage applications and analyze results on an ongoing basis . The State's Mortgage Down Payment Assistance Plan has been rejuvenated and the Department of Housing has taken a more aggressive approach to utilizing funds available. A centralized approach to First Time Home Buyers education programs is being developed . CHAMP (Connecticut Homebuyers Affordable Mortgage Program) , a program of flexible credit standards and low down payments , was created . This program has commitments from banks statewide of over $75 million . 349 5. Maine Port-Lender Homeownership Project Fleet Bank is among five Maine banks who have each pooled $250,000 for the Port-Lender Homeownership Project , a pilot homeowner/ landlord program administered by the City of Portland's Community Development office . The project represents a significant public/private partnership between the banks and the City . The program's goal is to improve the stability and livability of 1-4 unit properties in Portland's older neighborhoods by increasing owner-occupied properties and renovating local neighborhoods. City/Bank Housing Rehabilitation Loan Program The City of Portland annually receives a Community Development Block Grant under Title I of the Housing and Community Development Act of 1974. As part of their Community Development Program, the City assists low and moderate income property owners in the City of Portland . Fleet Bank's participation is to provide one-half of the amount of a housing rehabilitation loan , matched by a loan of a similar amount by the City , for eligible one-to-eight unit properties , containing a majority of households with low and moderate incomes . The aggregate amount the bank agrees to lend annually is $200.000 . Presently Fleet bank has 22 loans totalling $95,000.00 . Bangor Hydro-Electric Company Residential Conservation Loan Program The purpose of the program is to provide low cost funds to Bangor Hydro customers for rehabilitation for reducing electrical consumption/costs . Fleet has renewed its commitment to this program for 1992-93 , and is the only participating lender underwriting these reduced rate low cost loans . Current volumes as of 9/13/92 are 21 loans at $72,000.00 . Western Maine Land Trust . Six Unit Low- Low Income Affordable Housing Project - Porter Hill Farmington Fleet has committed to finance a $75,000 one year construction loan for three of the units , and subsequently finance the units (through FREF) . MSHA 7 350 Exhibit 2(b) THE SECOND MORTGAGE MARKET BY INSTITUTIONAL TYPE OF PLAYER, 6/30/82 (Dollars in thousands) -OUTSTANDINGS , 6/92OPEN-END OF CLOSEDSECONDS LENDERS HEL TOTAL BANK HOLDING COMPANIES 1.489 68,594,254 46,095, 30s 114,689,959 BANKS NOT PART OF ANY HOLDING CO. 6,356 11,777,859 10,663,248 22,441,107 SUBTOTAL