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With First Deal Closed, Impact Community Capital Looks To Innovate Again

Property Insurance Report

October 16, 2000

Impact Community Capital LLC was formed by several insurers in 1999 with the promise to help insurers to invest in urban areas. With its first $40.5 million deal completed and closed, the California company is now closing in on both a repeat of its first deal, and an innovative new deal structure as well.

Impact closed its first deal in August, purchasing $40.5 million in mortgages for multifamily housing units from the California Community Reinvestment Corporation (CCRC), a nonprofit lending consortium funded by 45 member banks and thrifts throughout California. CCRC finances housing for low income and moderate income families. The mortgages covered 12 multi family rental housing properties comprising 1,456 residential units.

By purchasing the mortgages, Impact frees up capital for CCRC, and enables it to make additional loans for this type of housing. Though there have been some attempts at selling these loans previously, but without an entity like Impact it was not possible to get the consistent stream of deals necessary to attract secondary mortgage market support.

With this deal under its belt, Impact is going back to find another pool of a similar size and structure. As more and more money is pushed through this deal structure, the cost of doing the deals falls significantly and investor and rating agency comfort with the deals rises. It is very important that Impact repeat its success.

But Daniel Sheehy, president of Impact, isn’t content to ride just one structure. Impact is now forging ahead to form its first pool of single family mortgages, which opens up the opportunity for hundreds of millions of dollars more in mortgages that can be repackaged.

As a packager and investor in mortgages, Impact, as should be clear by now, has nothing to do with insurance. But the organization has everything to do with the future of insurance regulation. For the past decade at least, insurance companies have been under pressure to invest more of their assets in urban areas. The federal Community Reinvestment Act has successfully pushed bankers to make more loans and investments in urban areas and minority communities, and regulators give each bank a CRA score based on their activity. Fail to invest properly, and the regulators start to put the squeeze on a bank.

This is precisely the structure that some politicians and neighborhood groups have had in mind for insurers. Critics of insurance company commitment to urban areas have been emboldened by their dramatic success in the 1990s in forcing insurers to change their underwriting and marketing strategies to better serve the inner city.

But there is a major problem in trying to extend the Community Reinvestment Act to insurers: insurers don’t make loans, they invest in them.

Impact was formed to enable insurers to participate in community reinvestment in a way that fits their business structure. Insurers have no infrastructure for making loans, servicing loans, managing foreclosed collateral, etc. Banks, and nonprofits such as CCRC, make loans. But urban development loans are rarely of the quality that banks can hold as capital acceptable to bank regulators, so the volume of such loans is limited. In buying up these loans, insurers free banks to go back to the streets and make more loans.

The trick is in making it possible for insurers to do something with the loans without running afoul of their regulators.

That’s where the magic of securitization comes in. We visited this topic in April 1999, but it bears reviewing because we believe that Impact has clearly come up with a structure that could enable insurers to proactively invest hundreds of millions of dollars into urban areas with most of the investment being investment grade, and the remainder becoming part of the insurers’ high risk investment portfolio. Though the Impact deals aren’t exactly a chief investment officer’s favorite way to make money, it is far from charity. And if used correctly, insurers can put themselves in a position where they will not only do a great deal of good for others, but they will also protect themselves from costly regulation.

The basics of the first deal: Impact served as a broker, taking the $40.5 million in loans made by CCRC and repackaging them into bonds. As pure investments, no one would want to touch them, and the rating agencies would call them junk bonds. But through an investment banking practice called credit enhancement, a portion of the bonds are made strong enough to earn an investment grade rating.

The $40.5 million was cut up into three pieces, or “tranches.” The first receives the highest rating because it receives the first dollars paid by the mortgage holders.

This part of the deal represented $22.275 million of mortgages, and received an “A” rating from Standard & Poors. For those who are paying attention to such things, the coupon on this tranche was 7.9%.

The second tranche was $4.05 million, and because it is slightly riskier, coming in behind the first in getting paid, the coupon was 8.0%.

The third piece is the “subordinate piece,” which means if a mortgage defaults, it bears all the risk up to 35% of the deal, $14.175 in mortgages. Because of this higher risk, the coupon was 8.2%.

This final part of the deal is not rated. If it was held by a bank or insurer, these mortgages could not be counted as capital against which loans could be made or insurance risk underwritten.

By holding out 35% of the mortgages to protect the other bond holders, the rating agencies were comfortable giving an investment rating to the rest of the pool. Essentially, Standard & Poors is saying that out of a pool of $40.5 million in loans, it is a very solid bet that at least $26.325 will perform.

Who bought the bonds? For now, eight insurance company investors in Impact also bought up all the investment grade bonds.

The insurers who took part in the deal were Allstate, Farmers, Pacific Life, PMI Mortgage Insurance, SAFECO, State Farm, Teachers Insurance and Annuity, 21st Century, and a newcomer to Impact, Nationwide. They’ll hold the mortgages in their investment portfolio, right alongside hundreds of millions of dollars of very similar bonds that they buy and sell every day in the capital markets.

In the future, Impact will surely try to market its investment grade loans outside the pool of Impact investors, in an effort to create more liquidity and have an even bigger, ah, impact. But for now, the Impact investors are holding on to the first bonds.

As for the unrated subordinate bonds, those will stay with Impact for its own account. Because rating agencies are always very conservative on new deal structures, the size of the subordinate piece was extremely high at 35% of the pool.

That means these unrated bonds should perform pretty well and the investors in Impact should earn a pretty good return on them. Impact will do its best to earn as much as possible on this segment of the deal, so that later deals can have a smaller subordinate piece, and so that the investing insurers tie up as little capital as possible. The less this all costs insurers, the more mortgages they can take on through Impact.

For those who need to know, the loans are 10 year adjustables, so the bonds are comparable to a 10 year Treasury. The bonds don’t yield as much as the market, but they aren’t exactly passbook savings either.

The "charity" in this deal is in the willingness of insurers to take a lower interest rate for its money than could be found elsewhere in the market.

The fact that these mortgages are tied up with a nice bow doesn’t change the fact that the properties are designed to collect below market rents to help out low income families and fixed income senior citizens. But Impact tries to maximize the value of the mortgages, to maximize the efficiency of capital available for such investment so the most good can be done.

The new single family program represents an entirely new level of complexity in deal structure, but provides an exciting way to more directly impact lending for low income housing.

The program would call for a bank (unnamed by already identified) to originate loans under a private label program to fit a specific set of guidelines. It would require no downpayment, and is strictly for families with income that is not greater than 120% of an area’s median income. Teachers, police officers, fire fighters and other government workers would be eligible with income of up to 140% of median income to encourage them to live in the communities where they work.

The initial target would be for Oakland, San Diego and Los Angeles, and would specialize in the purchase of homes that require some level of rehabilitation.

The initial size of the pool is expected to be about $50 million, generated at a rate of about $2 million a month. Still six months to a year away, the deal works best if it involves the two federal agencies that manage the secondary mortgage markets, Fannie Mae and Freddie Mac.

We don’t have the space, or the confidence in our understanding of the deal structure, to go into greater detail, so contact us and we’ll direct you to Impact if you need to know more.

But suffice to say that this would be a unique program that would enable insurers to point at big dollars going directly back into the urban communities to the kind of borrowers who need help the most. And it would come at a relatively modest cost that is voluntarily made and controlled, not mandated and regulated by the state or federal government.

For now, Impact is focused on California, but the model is clearly useful elsewhere, with the most obvious opportunities in New York, Illinois, Texas and Massachusetts.