CDFI Ratings Remain Mostly Stable, With Two Outlook Revisions and One Upgrade Since January 2022

The number of U.S. community development financial institutions (CDFIs) rated by S&P Global Ratings continues to increase, and now stands at 13 issuer credit ratings (ICRs). Between January 2022 and June 2023, most ratings were unchanged but we revised two outlooks to positive based on improving net equity--indicating there is a one-in-three likelihood of an upgrade in the next two years--and we raised one rating in June 2023 based on strong financial ratios. Three ratings now have a positive outlook; the outlook on the other ratings is stable.

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CDFI issuance of rated debt (such as unsecured general obligation bonds or impact notes) between January 2022 and July 2023 totaled $250 million by one issuer, down from a peak of $575 million in 2020 by five CDFI issuers. This decrease is partially due to the recent availability of low-cost, flexible capital, although proceeds from rated bonds and notes remain a relatively large source of funds for the sector overall. Nevertheless, debt outstanding increased in 2022 and we expect it will continue rising through the end of 2023.

Balance sheet equity has trended up in recent years while our view of repayment risk in loan portfolios has generally trended down. The result is higher net equity ratios that we believe will contribute to rating stability and strength over the next two years. We calculate net equity by adjusting equity, or net assets, for projected loan losses and other factors. At the same time, asset quality, profitability, and liquidity generally remain strengths of CDFI credit quality, in our opinion.

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Why CDFI Rating Outlooks Are Stable Or Positive (Hint: It Involves Net Equity)

We expect CDFIs' equity-to-assets ratios will revert to their previous averages, but it may take longer than anticipated.   Higher equity ratios are not necessarily a primary mission of CDFIs. Management teams have indicated they plan to maximize their social impact through lending and bring those ratios back in line with past years'. We expect the rebound in total debt outstanding that began in 2022 will continue as CDFIs exhaust on-balance-sheet assets (including funds from prepayments and grants) and agreements with current lenders--leveraging up to meet the high loan demand will be a common strategy. As CDFIs look for new sources of lending capital, we think such ratios will decrease slowly in the near term, but not below levels commensurate with the current ratings.

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We expect the decrease in equity-to-assets will follow an increase in debt, but credit quality will likely not deteriorate in the near term.   Management is generally very strong, in our opinion, including teams' strategic use of debt to meet an increase in loan demand and work toward their social missions, and 2023 is no exception. CDFIs began issuing publicly rated debt in part because of its flexibility compared with traditional sources of financing, which carried various restrictions or did not match their loan terms. Should institutions leverage too much and too quickly, pressuring equity balances, key credit ratios could weaken below levels commensurate with current ratings. Given the higher equity ratios in 2021 and 2022, we believe increases in leverage are unlikely to spur negative rating actions in 2023.

The schedule of loan and debt maturities over the next five years shows CDFIs generally match the terms of their assets and liabilities, mitigating liquidity and refinancing risks prevalent elsewhere. Most debt is fixed rate, which also mitigates interest rate risk. Furthermore, short-term assets have averaged 18% of total assets over the past five years; combined with external liquidity facilities, these funds could be available for short-term liquidity needs.

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Financial institutions and publicly rated bonds or notes were the most common sources of CDFI debt outstanding in 2022.   Banks might lend to CDFIs as a qualified Community Reinvestment Act (CRA) activity or to fulfill certain policy-related goals or to advance racial equity. Should publicly rated debt prove cheaper than CDFIs' other sources, it's possible we will see that option used more often; however, rated issuance in 2023 will likely not reach previous years' levels.

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CDFIs could reduce their leverage through the receipt of grants to use as lending capital.   Grants include awards from the CDFI Fund or other philanthropic sources, which have supported lending in underserved communities. Such money might contain restrictions on their use (such as the time within which institutions must use the funds, or the purpose for which the money is applied). CDFI Fund programs such as the Capital Magnet Fund can be an uncertain funding source since awards vary by amount and recipient each year; per the CDFI Fund, there was no 2022 funding round based partially on the significant number of awards in 2021; 2023 awards will be announced in the fall.

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CDFI balance sheets remain in growth mode, with no signs of slowing in 2023.   Median CDFI equity has increased in each year since 2018 even though median debt outstanding rose faster than median total assets in three of the past five years; in the other two years, CDFIs paid off more debt than they took-on while their balance sheets continued to increase. Asset growth was slower in 2020 through 2022 than in previous years; increased competition from other lenders, and prepayments and refinancings exceeding loan originations spurred a deceleration in loan portfolio growth. Institutions stored these prepayments in short-term assets on their balance sheets, along with grants they continued to receive from various sources. Now that prepayments have slowed, following the Federal Reserve's (Fed) interest rate hikes, and loan demand has picked up dramatically, many CDFIs are deploying those short-term assets into new loan financings that carry higher interest rates than loans financed in 2021 and early 2022.

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We expect loan portfolios will increase in 2023, with a continued focus on housing and education-related properties.   Some borrowers that put projects on hold in the past year or two have proceeded with their plans this year. In other cases, CDFIs have received loan applications from developers who would otherwise go to traditional banks, as competition from bank lending began receding for some CDFIs in late 2022. As S&P Global Ratings noted in "What Declining Commercial Real Estate Values Could Mean For U.S. Banks" published June 5, 2023, on RatingsDirect, banks have slowed their commercial real estate lending in part due to concerns about credit quality and a reduction in risk tolerance stemming from declines in their deposits amid recent turmoil in the regional bank sector.

Most rated institutions focus their lending on multifamily housing and education-related loans (such as for charter schools), which can be supported with federal credit enhancement. We expect these sectors will remain most prevalent and believe CDFIs' commercial lending could pick up if those commercial projects fit within CDFIs' risk tolerances and strategies (particularly given a slowdown in commercial real estate lending from banks). The balance of small business and retail loans increased between 2018 and 2022 while commercial and manufacturing-related loans decreased slightly. In addition to CDFIs' new loan financings, higher portfolio balances include loans with extended maturities for reasons that include delays in borrowers receiving other funding (takeout sources) or construction delays.

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In 2022, about 49% of portfolio balances were for permanent loans and 45% were for either construction or acquisition purposes, although the mix of loan types varies across CDFIs.

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Our analysis assumes lower loan losses to current loan portfolios than in 2018.   The cash flow strength of permanent loans and the presence of mitigants to repayment risk for early-financing loans have led to a decrease in our assumed loan losses compared with five years ago. The median loan loss assumed in 2018 was about 26%, compared with a median of about 19% in our most recent analysis of CDFI portfolios, with variations based on portfolio composition and the stress scenario assumed at each rating level. Loan losses range from a low of near 8% for a portfolio consisting predominantly of permanent multifamily housing loans to a high of about 27% for one with a portion of small business loans. Our assumed losses are generally higher for non-housing loans (commercial, health care, or retail facilities) or early-financing loans due to volatility or uncertainty of cash flows, lack of a takeout commitment, or the absence of adequate reserves.

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The Fed tested capital levels at 23 of the nation's large banks by applying certain stress scenarios in this year's Dodd-Frank Act Stress Test. The result was a median loss rate of 6.2% overall, and a median loss of about 9% for commercial real estate (domestic) loans (see "Banks Held Up Well In The Fed's Stress Test, But They Likely Won't Ramp Up Share Buybacks," published July 7, 2023, on RatingsDirect). Furthermore, our assumed losses for CDFIs consider an even more stressful repayment risk than actual nonperforming assets (NPAs) in their loan portfolios, which had a median of 1% in 2022. Even at loan losses greater than the Fed's stress test and CDFIs' reported loan performance, institutions have sufficient equity to sustain operations during difficult circumstances at current rating levels, in our opinion.

Certain Key Credit Factors Are Perennial CDFI Strengths: Asset Quality And Profitability

Sound underwriting and strong portfolio oversight are why asset quality will likely remain extremely strong, even for lenders of a diverse mix of property types.   There was a slight uptick in NPAs in 2021, spurred largely by pandemic-related economic effects, or project delays due to limited availability of outside financing. Overall, however, NPAs were very low in 2022 at a median of 1% of total loans and real estate owned. Although we may assume more losses on non-housing loans in our rating analysis, delinquencies and impairments have not materially differed by property type. In our opinion, this is at least partially due to qualitative strengths of CDFI management teams, including their internal risk assessments and mitigants in place for loans that present any level of risk to their capital. Still, CDFIs held loan loss reserves at a median of about 3% of total loans in 2022, reflecting their risk awareness.

The average delinquency rate for commercial banks' real estate-secured loans is higher than those financed by CDFIs, although the gap narrowed in 2022. Based on our conversations with management teams, CDFIs expect loan performance in 2023 will mirror that in past years, near or below 1%; in comparison, delinquencies for banks' real estate-secured loans (residential, commercial, and farmland) were about 1.2% during the first quarter of 2023.

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Profitability remains strong despite fluctuations in revenue and a decrease in loan interest rates last year.   CDFIs' weighted average loan interest rate decreased by a median of 12 basis points between mid-2021 and mid-2022. A slowdown in loan originations, combined with more prepayments from higher-rate loans, contributed to a decline in loan interest income and lower profitability ratios in recent years, but key metrics remain what we consider strong. In certain instances, higher-rate debt that contained make-whole provisions constrained profitability for some CDFIs. The median return on average assets of 1.9% is extremely strong, in our opinion, while the median net interest margin of 2.3% represents recent compression of spreads.

New loans financed toward the end of 2022 and through 2023 will likely push interest margins wider.   We expect institutions' interest income will increase faster than their interest expenses. Loan interest is less cyclical than other revenue sources and could mean high interest margins should the costs of capital remain relatively low. Even through periods of slower lending in 2022 and early 2023, some CDFIs sought to capture higher yields on investments, pay back other debt, and use the earnings for future loan financings. We believe CDFIs will end 2023 with wider interest margins as they finance more loans with higher rates, albeit at a lag to increases in national interest rates.

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