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What CDFIs Should Expect in a Recession – Part 1

9/6/2022

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As economic indicators increasingly point to a recession, understanding a recession's likely impacts on our industry can help us react strategically as the economy changes. This is critical for any sector, but for CDFIs it is not just an existential moment to ensure self-survival, it is an urgent call to action to be economic first responders for our most vulnerable neighbors and communities. Just as airplane passengers should put on their own oxygen mask before helping others, CDFIs should ready themselves now so that they can support their constituents when an economic emergency arrives.

This is the first in a three-part series that will consider the likely impacts of a recession on the CDFI industry. Part 1 focuses on the negative impacts, Part 2 focuses on the potential silver lining, and Part 3 provides suggestions for how CDFIs can position themselves to thrive—recession or no recession.

Part 1: Negative Impacts

Goodbye to Easy Money?
The CDFI industry is enjoying an unprecedented infusion of capital from multiple sources—our industry’s version of “easy money.” The CDFI Fund airdropped over $1 million straight to the net assets of most CDFIs in 2021, and initiatives from LISC’s Black Economic Development Fund to OFN’s Finance Justice Fund and many more are deploying capital raised from corporate treasuries that in many cases had never invested in CDFIs before, or never at such scale. A recession, however, could slow or reverse this trend. As government budgets tighten and corporate boards increase an emphasis on cash on hand to mitigate recessionary risk, we can expect that the flow of new money into the industry will slow.
​
Rising Default Rates
A natural first concern for lenders in a recession is that delinquencies and charge-offs will increase. Data show that this concern is well-founded. An OFN study* of unregulated CDFI data from the 20 years from 1994 to 2013 found that the highest average delinquency rate and net charge off rate occurred in 2009 and 2010, respectively, correlating to the Great Recession (note that these high watermarks were still very manageable, at 5.8% for delinquencies and 2.1% for net charge-offs). While CDFIs should be ready for an uptick in problem loans, the impact is likely to be worse for small business lenders rather than real estate lenders. As the graph below shows, small business closures peak in recession economies.
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U.S. Bureau of Labor Statistics data compiled by Investopedia
 Real estate lenders, on the other hand, will likely see more resilient portfolios. Rents at a multifamily complex are paid by tenants who may collectively source income from dozens of employers and several public subsidy sources, decreasing the likelihood of broad nonpayment that could dent cash flow available for debt service. In the charter school lending sector, while a recession may hit government budgets and flow through to school budgets, charter schools tend to have many levers to pull to tighten their budgets and remain in operation—only the highest leveraged, and those with the most expensive leases or debt, are likely to be severely impacted by recessionary budget cuts.

Given these factors, it is the same small business lenders who are only recently emerging from pandemic-driven havoc in the portfolio that should prepare for a new uptick in problem loans.

*Source: 20 Years of Opportunity Finance 1994-2013: An Analysis of Trends and Growth. Published by the Opportunity Finance Network on November 10, 2015.
Extensions, Extensions, Extensions
While defaults caused by operating challenges are less likely for real estate lenders than small business lenders, real estate lenders will not be unscathed in a recession. The many CDFIs involved in predevelopment lending for residential real estate should expect a significant increase in extension requests. We’ve already seen this begin. In recent months delays in project closings have been caused by rising interest rates, escalating construction costs, supply chain snags and—less talked about but very problematic in our experience—staffing shortages at government agencies.
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As interest rates continue to rise and before inflation moderates, gaps in construction budgets will only become more frequent. A hard recession could have the compounding impact of lowering bank profits and therefore lowering the appetite for tax credits, driving down LIHTC pricing. In 2016 we saw a similar issue with a different cause, as reductions in corporate tax rates resulted in LIHTC pricing dropping by 5-10 cents per credit or more—creating million-dollar-plus gaps in projects. Real estate developers will need to get creative to cobble together sources of funding or reduce costs to get projects to the finish line, often requiring more time than anticipated when their predevelopment funding closed. For projects that ultimately fail to move forward, by the time a project is finally abandoned corporate guarantees may be weaker than they were pre-recession, as the compounding impact of project delays and lower income from operating properties lowers developer fee receipts and cash flows from partnership waterfalls.

​What’s Next
Now that we’ve covered the most likely negative impacts of the recession, the next post will review the potential opportunities that lie within a recession. After that, we will cover the steps CDFIs and other industry stakeholders can take to ensure that we are all ready to react strategically and proactively when a recession hits.
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  • Home
  • About High Impact
    • Our Team >
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    • Annual Reports
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    • Green Lending
    • For Real Estate Lenders
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    • For NMTC Allocatees
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