The L.A. Community Development Bank: It’s Not a Panacea!

Despite what you may hear on talk radio, politicians are people, too. That's why one can understand their euphoria about the Los Angeles Community Development Bank (CDB). From federal cutbacks to the County's budget hemorrhaging, 1995 has been a bad year for cities; so it's hard not to seize on the little good news around. 

Thus, Mayor Riordan calls the CDB "a powerful new tool of job creation and economic development." Councilmember Mike Hernandez predicts that the CDB "could change the course of Los Angeles." The Urban League's John Mack, no fan of the mayor, says that the CDB is has "the potential for a far-reaching impact south of the Santa Monica Freeway." 

The Los Angeles Times chimes in that the bank will create "thousands of jobs in poor neighborhoods." Even the Chief Administrative Officer's official report, a sort of document not known for its breathlessness, argues that potentially the CDB "will be both a catalyst and a continuing source of economic assistance for the overall revitalization of a large portion of the City's most economically disadvantaged areas. The benefits from increased job opportunities and the resultant economic empowerment of the residents of these areas can serve to renew whole neighborhoods."

There’s one problem with all these cheery assessments: they're not true. The CDB is a good development for Los Angeles. But it is not that good of a development. The record of community development institutions is decidedly mixed. At best, the CDB can make one small contribution to urban economic development. 

This is more than just a matter of emphasis. Through their rhetoric, officials are laying the groundwork for a political debacle. Overselling the CDB today ensures its extinction tomorrow. 

Community Development Banks—A Primer

To hear an economist tell it, community development banks shouldn't exist at all. The logic is straightforward: a bank would be foolish to deny a loan to a potentially successful business, because then it would deprive itself of income. Capital "shortages" in low-income areas, the argument concludes, are not shortages at all but rather the market accurately pricing the riskiness of investments there. It follows, then, that community development banks are doomed to failure. 

Few outside the Reason Foundation would swallow this argument whole, because banks operate in real life, not in textbooks. Most banks require businesses to have been in operation for three years, possess substantial collateral, and low leverage ratios. Such conditions make many profitable businesses unbankable. Venture capital will hardly fill the gap: small businesses in low-income neighborhoods rarely figure to go public. In addition, no one in South Central Los Angeles needs to be reminded about "redlining" in minority neighborhoods. 

Thus, community development banks can fill important niches in the urban economy. They always operate, however, under tension. On the one hand, they must stay away from bankable businesses and lend to low-income enterprises. On the other hand, they must maintain financial stability. Somewhere between these two imperatives lies a zone where community development banks can be effective. 

But no one knows how large this zone is. "We only know," note the authors of a leading study, "that [the zone] is more than argued by finance professors who preach completely efficient markets and less than asserted by community groups who equate need with creditworthiness." No one denies that lack of capital has choked off some businesses, but in the words of a board member of the Industrial Cooperative Association, a technical assistance organization in Massachusetts that focuses on low-income businesses, "it is a myth that many low-income businesses exist, or at least are straining to be born, but are held back by a lack of capital, training, and other resources. The reality is that business ownership is substantially outside the experience of most low-income people." 

The test of community development banks, then, lies in their historical record. That record contains numerous successes, but it also demonstrates the critical limitations of CDBs as an economic development tool. 

The Strange Career of Community Development Banks 

Consider Chicago's South Shore Bank, the most celebrated example of how community development banks can supposedly turn neighborhoods around. President Clinton has repeatedly cited South Shore in support of community development banks, and Los Angeles officials have seized on the South Shore experience to bolster their hopes for the CDB. While South Shore has accomplished a great deal, however, it has failed in precisely the sort of small business development that the CDB sees as its bailiwick. 

South Shore Bank was founded in 1971. Its name refers to a low-income and working class community on Chicago's South Side that between 1960 and 1970 turned from virtually all-white to almost entirely Black American. Economic decline accompanied the racial transformation, and low-income Black Americans were left with the shell of the urban economy. 

South Shore's original mission sounds hauntingly like the promises made for the CDB. Its founders envisioned a private, for-profit financial institution that would lend in a capital-starved and redlined area of the city. But then the new owners of South Shore found out more about the banking business and the problems of urban economic development. Most of their efforts at catalyzing business expansion failed. By the mid-70's, South Shore had completely abandoned business development.

South Shore obviously hasn't collapsed; instead, it has prospered by making real estate development loans. Its specialty is loaning to "home equity entrepreneurs," residents of South Shore who buy dilapidated housing stock, rehabilitate it, and then sell it at a profit. Such work takes entrepreneurial skill and not a little sweat equity. But these loans hardly catalyze the urban economy. Housing development creates jobs in construction, but it cannot serve as a long-term economic base. 

There's no magic to why housing succeeds when business development fails. People need affordable housing. Los Angeles must create thousands of units each year just to stay even. Thus, there will always be a demand. 

But there is no similar demand for business to locate in low-income neighborhoods, because low-income residents have less money to spend, and businesses haven't seen the need to be precisely where their customers are. Thus, aside from local stores, business districts rarely locate in low-income neighborhoods. Moreover, low-income  areas add enormous costs to operations in insurance and security. 

Building housing is inherently less risky. If a real estate deal goes bad, the lender at least has the collateral of the property itself. Failed small businesses, however, usually have nothing but accumulated debts. Add to this the advantage of federal housing subsidies—from home mortgage deductions, to low income housing tax credits, CBDG and HOME funds, and Section 8—and the story becomes clear. 

The brute fact is that no one really knows how to achieve major business development in low-income neighborhoods. That's why the best advice to development banks is: husband your resources carefully. Move slowly; get to know the neighborhood you are working in very carefully in order better to assess the personal trustworthiness of loan applicants and discover what the neighborhood will support. South Shore did not hit even upon a formula for housing development until its first decade was finished. Most importantly: don't expect too much. Work in particular niches, but do not attempt to transform an area. 

Hitting the Ground Racing—and Perhaps Stumbling 

The CDB's current business plan seems to move in just the opposite direction. Of $430 million in HUD funds, the CDB has established a benchmark to utilize more than 30% in the first two years, much of that through risky venture capital. Moreover, the CDB will not make loans itself, but lend to intermediary institutions, none of which have been chosen, and many of which do not even exist yet. This accelerates the timetable. 

Still, one might ask: where is the downside? The CDB promises a bold new initiative. Isn't experimentation a good thing? Here, the answer is no, for both detailed and big-picture reasons. 

The detailed reason is that HUD has given loan guarantees, not a grant, to the CDB. If the CDB loses money, the private banks that put up most of the CDB's capital can get reimbursed from HUD. Getting the money out on the street too quickly, while driven by good intentions, may mean taking too many risky deals and thereby drawing down on the HUD guarantee. The CDB has prudently established a loan-loss reserve fund, but that fund cannot be expected to cover an unduly risky loan strategy.

This isn't just a matter of the CDB having egg on its face. HUD, like any loan guarantor, wanted some collateral, so the City agreed to collateralize the CDB with Los Angeles' future funds under the federal Community Development Block Grant (CDBG) program. In other words, HUD can recoup unpaid loans by cutting Los Angeles' allotment under the CDBG. 

This trade-off threatens dire problems for low-income people. CDBG funds can be used for vital social services such as job training, education, child care, gang prevention, recreation, etc. And contrary to popular perception, these social services have helped lift people out of poverty. Social services often appear ineffective, because their beneficiaries don't revitalize a neighborhood; they move out of it. But the outcomes have been demonstrated. Thus, the desire to get money onto the street could easily harm the very people it seeks to help. 

The CDB incorporators, in good faith, have attempted to mitigate this danger by promising that CDB profits can be used for social services. But given the inherent riskiness of using the CDB to accomplish business development, counting on such profits seems overoptimistic at best. 

Back to the Future

But this scenario obscures the greater danger: the current discourse surrounding the CDB threatens to reap a political disaster for Los Angeles. CDB advocates have promised a great catalyzation of urban areas. In two or three years, however, middle-class television watchers will still see images of depressed and dangerous ghettoes. The resulting inference, no matter how false will be politically irresistible. Community development banks, like everything else the government tries, are doomed to fail. Better to get government out of helping urban areas at all. 

This isn't doomsaying: it is the literal history of the War on Poverty. The War on Poverty was always a tiny program. The largest budget for the Office of Economic Opportunity, its administrative arm, was $1.9 billion in 1971. Moreover, a good bit of the War on Poverty was successful. Job Corps and Head Start, two key components of Lyndon Johnson's original legislative package, have been shown conclusively to improve outcomes for low-income people. 

Yet now, everybody "knows" two things about the War on Poverty: one, it represented a massive infusion of federal money; and two, it was a miserable failure. How could this have happened? Why do people believe things completely at odds with the historical record? 

The answer is that the War on Poverty was grossly oversold, the same strategy that CDB advocates now appear to be following. Sargent Shriver, the OEO's first director, promised the country in 1965 that poverty would be eliminated by 1971. Lyndon Johnson used inappropriate military metaphors to raise expectations: "Our goal is total victory," he told the nation. People believed him. 

Then, when the bloated promises failed to come true, people believed conservatives who told them that the War on Poverty was a failure. Now, no matter how many library shelves groan with studies demonstrating the success of War on Poverty programs, the public won't listen. 

Enemies of cities are poised to do the same to community development banks. Conservative politicians arc relishing the chance for a photo opportunity in the heart of South Central to "prove" that the CDB, like all government programs, doesn't work. The next step will be familiar: defunding of yet another program to help cities. The CDB's effort to empower low-income urban residents flies in the face of an agenda dominated by those who would abandon cities and throw governmental largesse onto suburban areas.

Already, these forces have gutted HUD' s budget and are looking to do the same for social services. Unless the rhetoric on the CDB is toned down and the promises muted, it will be that much easier for them to destroy it as well. They are ready to pounce. Are we ready for them?