The Growth Coach

It’s Time to Shut the L.A. Community Development Bank
Jonathan Goldhill
By JONATHAN GOLDHILL

The Los Angeles Times recently ran yet another article about the failure of the L.A. Community Development Bank to meet its goal of creating a viable financial institution that could help fuel job creation in the inner-city south of the downtown central business district.

Only this piece was squarely targeted at the failed partnership with Zone Ventures. This fiasco of public dollars could have been averted.

L.A.’s problem began in 1995 when the federal government awarded Empowerment Zones as part of a federal mandate to assist deteriorating urban cores across the country. Designed by policymakers to benefit densely populated inner cities, these programs were awarded only to cities east of the Mississippi with significant urban centers.

In an effort to appease government lawmakers and their constituents in the West, cities like Los Angeles received a consolation prize. HUD provided $435 million to finance the Community Development Bank, which was hastily set up without a solid sustainable business plan.

Problems widespread

Moreover, it was announced at a time when the City of Los Angeles was not being effective with their programs. Many of its detractors decried that the bank would fail, but policymakers, bureaucrats, and economic development supporters benefiting from its formation did not listen.

The failure of the bank to meet its investment criteria has occurred in all areas of its strategic plan and business operations:

• Its high default and delinquency rates have been exceptionally high even for loans to marginally creditworthy borrowers. Granted, these are high-risk loans. With conventional default rates for lending institutions in the 1-2 percent range, even their anticipated default rate of 10-15 percent far exceeds their actual default rate of 32 percent.

As a lender to post-earthquake borrowers in the San Fernando Valley, I know. We were granted funds with similar expectations, but far exceeded them with low single digit default and delinquency rates among similarly high-risk loans.

• Management turnover at the bank has been astronomically high. In the six years since it opened in 1995, the bank has gone through no less than four chief executives.

• The bank’s borrowers have failed to create the jobs required from their use of government funds at a rate of 1 job per $35,000 in the target area. A review by HUD found that only 20 percent of the jobs created by borrowers went to residents in the 19-square-mile area served by the bank. No information is yet reported on the dollar-to-job creation ratio.

The deal made with Zone Ventures was never going to meet the bank’s job creation objective, nor was it ever going to serve inner-city residents, the original purpose behind the bank. Access to public funds, along with the typical 2 percent management fee and carry on returns to the partnership, apparently motivated Draper to form Zone Ventures and capitalize on an opportunity to expand their operation.

The bank’s partnership with Zone was rooted in thinking it could make up any loan portfolio losses on the upside of dot.com successes. The reality of it everyone knew – the job creation goals would never be met, as all the hires would be highly educated professionals. And, in the end, the dot.com craze went the way of junk bonds. Today, the bank pays Zone’s staff of 4-6 people nearly $500,000 per year to cover management fees – a significant chunk of the bank’s administrative budget of $875,000.

• The bank now faces a situation where it cannot meet current interest payment obligations on its note to the federal government to the tune of $300,000 per year.

How to fix problem

The problems with this ill-fated institution may not have been prevented, but blame can be evenly distributed. While lending to borrowers with marginal creditworthiness is a tough business, a better-researched and coordinated plan could have been developed from the start.

Now, the City’s future Community Development Block Grant funds, which it pledged as guarantees to leverage the bank’s assets, are at risk, which could affect our neighborhoods in the years to come.

So what can be done to fix the problem?

Perhaps the best recommendation at this point is to close the bank. Terminate the Zone Ventures agreement. Hire a consultant to re-evaluate the venture investment and make recommendations regarding their real value, sale and liquidation.

Also, evaluate whether these portfolio companies will ever meet HUD’s job creation requirements through the use of calls on the investment. Hopefully, these covenants were put into the investment agreement.

If additional investments into venture-backed businesses are not likely to meet the required social and desired financial returns on investment, the bank should consider all means of renegotiating their future capital investments.

And what lessons are learned here? First, the risk of failure is high when social engineering programs are used to help underserved communities that lack access to capital. Second, the political power of local officials to bring dollars to our community may be strong, but if the programs or their managers are not, failure to meet objectives is a likely outcome. Third, opportunists can take advantage of government programs if the administrators of these programs are willing targets.

Jonathan Goldhill is a principal at Jonathan Goldhill & Associates in Los Angeles.