| "THE COMMUNITY REINVESTMENT ACT"
OR VINEGAR FOR BANKS?
Joseph Fullop III Ph.D.
I have recently
received many requests to explain how Banks can turn the CRA compliance issues into
something that is cost effective and profitable. This article will attempt to explain to
laymen and professional bankers how this can be done within the myriad of regulations that
encumbers the banking industry. One should note however that these are rapidly changing
times. Conventional banking must adapt to this changing environment if it is to survive
and prosper. There are many ways a bank can serve its clients and community without using
conventional banking techniques. Through proper structuring a bank can substantially
reduce its risk of partial or total loss, increase its profits, receive tax benefits,
attain CRA credits, and lay a foundation for future entry into the IPO market.
A BRIEF HISTORY
The CRA rules and regulations were originally written to force the banking industry to finance low to middle income housing. During the time the ACT was being written and initiated the mortgage market opened up and changed the ability for the less fortunate to acquire a house mortgage. In order to salvage the ACT an amendment process started to broaden the scope of the CRA to aid the low to moderate income in other ways.
Many banks formed wholly owned, for profit, CDC corporations in order to comply with CRA regulations. These CDC corporations were well intended but most of the funds were never actually utilized as intended. Audits were a nuisance to banks but could be handled with some creative bookkeeping. The new rules however causes the banks to be audited on what they have actually done, not on what they intend to do. CRA under the new amendments are taken very seriously by the banking industry. The OCC is preparing to fine banks that are out of compliance. The new regulations do however broaden the scope of allowable financial transactions sufficiently to enable a progressive bank to turn this vinegar of legislation into very fine wine.
In order to solve a problem we must first define it. The first part of the problem is that the banking industry is restricted to normal lending laws whenever they loan money to a CRA qualified applicant. These rules require the bank to set aside $1.10 in their lost loan reserve account for every dollar they loan out under CRA. The potential profits for a loan of this type is limited. The cost of processing a CRA qualified loan is the same as any other loan if not more. The size of a CRA loan is traditionally very small because of the lack of assets accessible to the low to middle income. These problems and many more point to the fact that traditional lending will not be either profitable or practical for banks.
THE SOLUTION The CRA amended rules allow a bank to invest money as well as lending it. Investing money circumvents the normal lending regulations. Profits can be much greater from an investment and furthermore an investment has an upside potential. The problem with investing is that banks are ill equipped to analyze, structure, and execute an investment.
To qualify an investment structure under the CRA rules, and for a bank to receive CRA credit, the bank is required to attain an endorsement from a political subdivision on the project being funded. Economic Development Agencies are quick to respond to such requests. The final investment package, accompanied by the endorsement, may be submitted to the OCC for pre-approval for CRA credits.
Historically banks have been restricted from participating in the sale of securities because of the Glass-Steagle Act. The CRA is a crack in the foundation of Glass-Steagle for the banking industry and should be viewed as an opportunity not a problem.
The investment structure of choice will be a CDLP (Community Development Limited Partnership) as defined under the ACT. The Limited Partnership foundation of the CDLP is most appropriate because a Limited Partnership is the most flexible financial structure ever conceived because it is based on contract law. Flexibility is essential to the financial engineer that designs the structure. No two projects will be identical. Risk can be managed a number of ways by a financial expert.
The good news is that a structure exists that will qualify as a CDLP that can be made cost efficient and standardized in form. The structure can be used for start-ups, debt consolidation, expansion, loan phase-outs, and even reconstruction under Chapter 11.
The best way to explain how this structure works is to address an example:
In this example we have an industrialist that manufactures a widget. The bank has done business with the CEO for 12 years and feels comfortable with his leadership and ability. The present loan portfolio on this company is 2 million. The CEO has a new product line he wishes to introduce and has requested an additional 1 million to launch the product. The problem is that his assets to loan dollar ratio is considerably short and a conventional loan is out of the question.
Obviously an expansion of this type will create new jobs for the community. This fact will be sufficient to request a letter of endorsement from the local political subdivision. The bank now negotiates with the company to restructure the clients existing portfolio and add the additional capital needed. The results of the restructure will be the formation of a CDLP. The final offering will be presented to the OCC for CRA approval.
The bank, through its investment banking division, will offer the CDLP to the parent bank and other banks needing CRA Credits. The Parent bank, in this example, agrees to purchase 2 million dollars worth of the offering. The balance of one million is raised from 2 other banks. The original debt portfolio is now paid off in full. The Banks are now Limited Partners in the CDLP. All the assets of the company are safely parked in the CDLP. The CDLP is designed to be a safe harbor for assets. The OGP of the CDLP is the owner of the company personally. This is important to the client in that he still retains control of his assets even though they are now in the CDLP. The CDLP enters into a USE CONTRACT with the Corporation. The Corporation through the terms of the USE CONTRACT agrees to pay the CDLP a percentage of the gross income of the Corporation for the use of the assets. It should be noted here that the Corporation is designed not to make a profit. A Corporation is intended to protect the assets of the individual participants- no more- no less. The only thing left in the Corporation is labor, taxes, utilities, and insurance. The Corporation never earns any equity in the assets of the CDLP; therefore the USE CONTRACT is not a lease. It is a cost of doing business; therefore you have circumvented dividend tax and corporate profits tax. The CDLP is a pass through tax vehicle therefore all of the CDLP proceeds may be divided up within the CDLP on an appropriate basis. The assets in the CDLP are set up on a depreciation schedule and the depreciation is divided up among the Limited Partners on a pro-rata basis.
Attached to this article are quotations from the CRA regulations that pertain to what has been discussed herein. One should pay special attention to the definitions in this paperwork as well as the broadness of regulations as written. I have also attached to this article some additional articles that will better explain the CDLP structure and philosophy. These articles will answer a lot of questions you must have at this point.
FPRC has spent countless hours developing a memorandum form that can be used by banks and public and private companies to streamline the paperwork process necessary to implement the above described structure. FPRC's consultants will either train bank officials in the nuances of this structure or assign a consultant to implement the plan for the bank. Packaging the structure can usually be accomplished within a two-week period with FPRC's paperwork and assistance. Legal expenses are held to a minimum and attorneys are used for final review purposes only. Banks may use this type of structure for many clients and projects. It will dramatically enhance the bank asset to income ratios.
Banks need to have an investment banking division to implement this structure properly. If the bank does not have an investment banking division there are ways to do the offering through the local political subdivisions and reap the same benefits.
This form of syndication should be reviewed by banks that have satisfied their CRA compliance issues. There is no limit as to the amount of CRA credits you may earn, only a minimum that is required. If this process can become a fine wine then why not use it more often?
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