With demand for loans surging and investment capital from large banks drying up, community development financial institutions are caught in cash crunch.

Acting as intermediaries to banks, credit unions and foundations, the CDFIs provide low-cost financing to neighborhood developers and small-business owners that might otherwise have trouble obtaining market-rate loans.

Since last fall, CDFIs have been losing access to low-cost sources of funding from partner banks that are cutting lines or lending at higher rates. The dried-up secondary market for low-income tax credits has only added to CDFIs' woes.

Community development financing is in danger of sliding into a "permanently diminished role," said Mark Pinsky, the CEO of Opportunity Finance Network, a nationwide association of 170 CDFIs.

The problem has grown acute enough to grab the attention of Federal Reserve Chairman Ben Bernanke, who is calling for the creation of a broader and more diverse funding base to carry CDFIs through the current crisis and beyond.

CDFI organizers say banks have to be kept in the picture, since they provide 54% of the total funding for CDFIs.

"If we can't pull banks back into the communities, I think the level of disinvestment, unemployment and blight will increase very dramatically," said Calvin Holmes, executive director of the Chicago Community Loan Fund, which provides predevelopment financing for local retail, housing and nonprofit construction.

Since the formal designation of CDFIs in 1994, the Treasury estimates they have financed around $29 billion in small-business and affordable housing loans in poor communities.

In Opportunity Finance's second-quarter survey of about 100 member CDFIs, more than half reported being "capital restrained" and were boosting loan-loss reserves. Most expect "operating and liquidity challenges" to continue this year, with 30% expected to fund fewer loans to start-ups, nonprofits and housing developers. Meanwhile, the survey found that requests for CDFI funding are on the rise, in part because traditional financing has become off-limits.

Pinsky said his group is in talks with government officials to find "new ways of increasing liquidity, whether it's various forms of guarantees that would help investors put money into CDFIs" or getting additional awards from the Treasury's CDFI Fund, a division that handles financial assistance to institutions in economically depressed areas. The CDFI Fund responded in June with $90 million in awards provided by the government's stimulus package — with another round anticipated in September, for a total planned 2009 disbursement of $207 million.

The stimulus package also doubled, to $6.5 billion, the amount of New Market Tax Credits the CDFI Fund would back for approved community development investments this year.

But many think it will take more to fill in an expected 39% drop in available CDFI capital.

The CDFI Fund last year recommended that Treasury set aside up to $2 billion from Troubled Asset Relief Program funds for CDFIs.

The institutions have lost several of their primary benefactors of recent years, either to failure or mergers; Wachovia Corp., Washington Mutual Inc., and Merrill Lynch & Co. were among the most active funders of CDFIs. (The investments earn banks Community Reinvestment Act credit.)

The overall market downturn, too, has played a role; a recent study presented to the Fed showed that CDFIs were frequently found to have lost "concessionary" funding or short-term capital lines.

Self-Help, a community development credit union in Durham, N.C., had only hours to replace a $25 million overnight facility called in by a lender on the day Lehman Brothers collapsed.

Another CDFI had to cut ties with a lender that sought full collateral on loans already guaranteed by the Small Business Administration and ordered the CDFI to cede interest in the loans (a violation of SBA guidelines), according to Paul Weech, a former chief of staff with the SBA who interviewed dozens of CDFIs for the study.

Loans that are being renewed for CDFIs are coming with rate hikes of 200 to 250 basis points, according to Weech.

The market for low-income housing tax credits is perhaps the most critical loss for CDFIs. In recent years the credits had provided about $8 billion annually in equity financing for developers of affordable housing projects as they neared closing. But 40% of that volume came from Freddie Mac and Fannie Mae purchases, which were halted in the spring of 2008.

Without the tax credits, banks became hesitant to pick up predevelopment loans. That forced ShoreBank Enterprise Detroit, a nonprofit arm of ShoreBank in Chicago, to turn away from funding new developments almost exclusively in favor of rehab projects.

In his June remarks on CDFIs, Bernanke called for bringing new venture capital investors into the stagnant low-income housing tax credit market.

Some of the market has been ameliorated with a program under the 2008 Home Economic Recovery Act to provide grants to states in lieu of tax credit investments for housing developers. The act also opened up another possible new funding channel for CDFIs: membership in the Federal Home Loan Bank System. So far, only a "small number" of CDFIs — those that are banks, thrifts and credit unions — will have the capacity to qualify for collateralized advances for lending, said Pinsky, whose network is negotiating less restrictive terms on CDFI asset requirements with the Home Loan Bank System's regulator, the Federal Housing Finance Agency.

Some questions have been raised about whether those same regulatory issues are holding back Treasury from offering up Tarp funds, as recommended by its CDFI Fund board. To date 15 have received Tarp funds, for a total of $132 million.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.