Banking with Heart

Fallout from the subprime crisis has been enough to make most bankers run, tails between their legs, away from any mortgage that carries the slightest whiff of risk. Then there’s ShoreBank Corp., which last September, just as the depth of the crisis was unfolding, hired a third-party firm to comb property records in some of Chicago’s poorest neighborhoods, identifying 10,000 homeowners at the highest risk of default due to predatory loans. It then began offering many of those folks a chance to refinance into fixed mortgages at reasonable rates.

By the end of 2008, CEO Joseph Hasten, 56, expects to have originated about 1,000 such loans, with a total exposure of $150 million on the books. “That’ll put a dent in that 10,000 number,” he says. “We weren’t going to stand around and let the effects of this subprime problem make its way through our neighborhoods.”

The Rescue Loan Program, as it is called, u00e2u20acu0153is creative and innovative, and it’s exactly what we can and should be doing at a time like this,” says Eugene Ludwig, former Comptroller of the Currency and a ShoreBank director since 2001. It’s also par for the course for this decidedly unconventional Chicago-based lender that has always worn commitment to its core low- and moderate-income clients-and more recently, the environment-on its sleeve.

From modest roots as a $37 million community development bank in Chicago, ShoreBank has blossomed into one of the most complex $2.4 billion banking organizations you could expect to find, and one with a clearly defined social mission that goes beyond simply making money.

Along the way, it has emerged as a standard-bearer for the growing sustainability movement. The term, at least in ShoreBank’s context, has a dual meaning: economic sustainability through lending programs that promote job growth or homeownership in areas that other banks traditionally shun, and a broader goal of environmental sustainability, accomplished by leveraging the carrot of financing to prod customers into using ecofriendly building materials and business practices.

The company runs community development banks in Chicago, Cleveland, and Detroit, and rural Washington and Michigan, among other markets. It also provides advice and seed money for development lenders in places like Afghanistan and Cambodia, and produces cutting-edge research on banking the “underbanked” around the world.

ShoreBank was instrumental in helping Muhammad Yunus, winner of the 2006 Nobel Peace Prize, launch Grameen Bank, the Bangladeshi microlender. It also has been hailed by former President Bill Clinton, who modeled the Treasury Department’s Community Development Financial Institutions Fund after ShoreBank’s experience. The CDFI Fund provides financial awards and incentives to banks that satisfy certain criteria in areas such as affordable housing and economic development lending.

Along the way, ShoreBank has occasionally ruffled some industry feathers: In 1977, cofounder and current Chairman Ronald Grzywinski was the only banker in the country to testify before Congress in favor of the Community Reinvestment Act, sitting opposite the head of the American Bankers Association. That didn’t win him a lot of fans at the time. Even so, most big banks applaud ShoreBank’s efforts and use its research, including the likes of JPMorgan Chase & Co. and Bank of America Corp., both of which are among the company’s 71 shareholders. Banks can fulfill part of their CRA requirements with deposits or investments in community development banks.

One of the biggest differences between ShoreBank and other banking companies is that the board employs a “triple bottom-line” approach to the business, measuring success not only in terms of earnings, but also how well management is fulfilling its development and conservation missions.

“Everything has to pass through that gauntlet,” says director Nicolas Retsinas, a former chairman of the Federal Housing Administration and former head of the Office of Thrift Supervision, and now director of Harvard University’s Joint Center for Housing Studies. “There’s nothing the board will approve just because it’s mission. And there’s nothing where we don’t ask, ‘What impact does this have on issues of social equity or the environment’?”

The board sets specific targets to ensure its lending objectives are achieved. In 2008, for instance, the Chicago bank aims to originate $450 million in development loans and $150 million in conservation loans. The whole idea is backed by incentives: Loan officers’ bonus payments are based on their ability to hit individual targets in all three categories. “You might hit the ball out of the park on earnings, but if you miss the targets on the environmental and development issues, you’ll get a chance to try again next year,” Grzywinski says.

But make no mistake: ShoreBank isn’t in business to provide handouts. “It’s always been, ‘No money, no mission,’” says Spencer Beebe, a holding company director since 1995 and the president and founder of Ecotrust, a Portland, Oregon-based conservation group that is a major shareholder in ShoreBank Pacific, the Washington affiliate. “The idea is to use the structure of a bank holding company to promote a social and environmental agenda, as well as an economic one, while making a profit.”

The heart, soul, and financial engine of the organization is the Chicago bank, which also includes lending operations in low-income neighborhoods of Detroit and Cleveland under its charter. The bank has done nearly 60,000 unsubsidized loans over the years, predominantly to black homeowners and mom-and-pop rehabbers.

More than half of the bank’s residential mortgage borrowers have credit scores below 620, technically qualifying them as subprime, but that in itself matters little. While ShoreBank typically obtains a borrower’s FICO score after the fact, it isn’t used as part of the underwriting, Grzywinski says. Instead, the bank scores loans on its own terms, placing relatively heavy weight on what’s gleaned from personal meetings.

“This isn’t 1-800-Ditech. If you want to borrow from us, we’re going to get to know you. We’ll meet with you one-on-one, get to know your character and background. And we already know the house you’re buying, the neighborhood and its value,” Hasten explains. “We have real knowledge of the borrower.”

The same dynamics are at play in the bank’s linchpin lending niche: mom-and-pop contractors who rehabilitate the aging and abundant multifamily housing stock on Chicago’s South Side. Hasten says the bank controls 60% of the local rehab market, succeeding because it underwrites those loans face-to-face and maintains a network of trusted tradesmen -plumbers, roofers, and the like- to aid in such projects.

Its lenders know the local rental market well enough to advise clients on how much rehab work a property can support without being priced out of the market. If a borrower runs into trouble, ShoreBank can usually tap its connections to quickly find another buyer for the property, keeping it out of default and preventing it from becoming a neighborhood trouble spot.

All that helps explain why, over its history, the bank has averaged just 18 basis points in charge-offs on that portfolio, says Mary Houghton, the holding company’s president and a director and cofounder. And why, in the midst of the toughest real estate market in decades, 90-day-or-greater delinquencies in May accounted for about 2% of the portfolio. Rivals operating in the same neighborhoods average delinquency rates above 10%, Hasten says. “This bank has saved neighborhoods. I’m convinced of it.”

More recently, ShoreBank has begun to target other niches, lending to medium-sized black churches and neighborhood health clinics – two sectors that both help make communities better places to live and are able to pay back their loans.

The overall impression is of a bunch of liberal do-gooders on their own little crusade to save the world, which isn’t far off. Among the biggest shareholders are philanthropies, such as the Ford Foundation and Kellogg Foundation, which are attracted to Shorebank’s progressive policies. Many of these institutions -along with banks, governments, and wealthy individuals- place some of their deposits with the bank as well, helping to fund lending initiatives. In fact, half of the bank’s depositors come from outside Chicago, Hasten says. “They deposit with us because of what we do.”

What’s less understood is that the mission-based lending, with all of its hand-holding, also serves as a powerful differentiation strategy capable of consistently generating a profit. Many ShoreBank subsidiaries lost money in 2007, but even in a tough operating environment, the holding company still reported earnings of $4.2 million. The core Chicago bank subsidiary had a net income of $11.2 million, according to SNL Financial LLC, with a return on equity of 7.88% and a return on assets of 0.52%. That’s lower than average: during the past five years, ROEs have often surpassed 15%.

John Garabedian, a Chicago-based senior partner with The Boston Consulting Group, led ShoreBank’s management and board through a strategic review several years ago. When it came to its core markets, “We couldn’t even show their competitors on the page, because [ShoreBank’s] market share was so large,” he says.

Garabedian’s assessment found that the biggest risks to ShoreBank’s income statement came earlier this decade, when it tried to act too much like an ordinary banku00e2u20ac”opening additional retail branches, participating in other banks’ loans. The board has since moved from that direction, and is again playing to its strengths.

“It’s amazing. Here they are lending to some of the toughest credits out there, and they’re making an attractive profit,”says Garabedian, who often cites ShoreBank as a model for other clients. “The emphasis on sustainability provides one of the clearest competitive advantages we’ve ever found for any company.”

For directors, serving on ShoreBank’s board has the feel of being involved in an experimental lab. They uniformly claim to be excited by the notion that, in some small way, they’re changing the world for the better, and take pride in their institution’s leadership as a sort of proof-of-concept in the development-banking world.

“Finding better ways to bank low- and moderate-income customers u00e2u20acu0153is a passion for me,”says Ludwig, now CEO of Promontory Financial Group, a Washington, D.C. banking consultant. While more than 50 development banks operate across the country, “ShoreBank has been the crucible in the United States” for the concept, Ludwig says. “It was revolutionary when they did it, and it’s still very innovative today.”

A network of 14 interlocking subsidiary boards reflects the organization’s complexity. In total, more than 100 individuals sit on one or more of ShoreBank’s boards, including business leaders, lawyers, pastors, executives from other banks, foundation representatives, university officials, and a host of nonprofit executives, among others. The individual operations are loosely knit, and they sometimes share insights with each other, although thatu00e2u20acu2122s not a priority.

Many directors, such as Ludwig and Retsinas, hail from outside ShoreBank’s core markets. Grzywinski says the board’s composition has always been less about “connections” than it is about “breadth of knowledge and wisdom.. We’ve always looked outside of Chicago to get board members who offer the best combination of business, talent and mission we can find.” Even so, there’s no disputing that having bigger, higher-profile names on the board instills a bit more caution, and outwardly at least leaves the company less connected to the communities it serves.

When ShoreBank got its start in 1973, the directors were mostly young local mavericks who pushed the envelope and heatedly debated key issues.”We used to have fights -good, long arguments like, “Is this the best place to put our resources? Does this fulfill our mission?’” recalls Richard Taub, a sociology professor at the University of Chicago who aided the founders in the early days and was a ShoreBank director in the 1980s.

Back then, “the directors were 100% behind taking chances. They were in uncharted territory -making loans where conventional wisdom said you shouldn’t. And they’d say, “‘That’s why we’re here. If we’re going to act like an ordinary bank, then let’s just quit now,’” he says.

By 2005, “the same intensity of commitment wasn’t there,” says Taub, who continued attending board meetings as an adviser until then. The board felt older, more interested in updates than debate. When he suggested the group seek more young blood, “the sense around the table was that anyone who was under 50 years old wouldn’t be able to handle the level of responsibility,” Taub says.

Not surprisingly, the sitting directors don’t view themselves as passive at all. Indeed, Hasten says the boardu00e2u20acu2122s level of involvement u00e2u20acu0153sometimes gets irritating. “There’s passion here, and sometimes the line between guidance, oversight and management gets blurred. But I’d rather they get accused of over-interference than the opposite.”

When the Rescue Loan Program was approved, the biggest discussions centered on whether or not ShoreBank could take it national. Actually pursuing the program was never really in doubt. u00e2u20acu0153This is something we ought to be engaged in. It’s too important for us to simply be a spectator, particularly given the impact on our neighborhoods,” Retsinas says. “It confirms the initial premise” of the company’s founding.

Much of directors’ time is spent ensuring that the “proper balance is maintained between mission and market,”Retsinas says. “The board members so buy into what ShoreBank is about. But we’re not cheerleaders. Our role is to be constructively critical lovers of the organization, and that’s what we are.”

As a regulated bank holding company, ShoreBank’s directors set policies and procedures and track and report net charge-offs, and return ratios, the same as any other group of directors. They are subject to the same capital and safety requirements, entertain examiners, and must comply with many of the basic corporate governance mandates in the marketplace today.

They also guide strategic planning and select the CEO. Last year’s hiring of Hasten “the first outsider to be named CEO in ShoreBank’s history” was sparked, in part, by plans to quintuple annual loan volume, to around $2 billion, by 2013. The board conducted a lengthy national search, complete with a head-hunting firm, before landing the former vice chairman of giant U.S. Bancorp in April 2007.

“We felt it was important at this point to have a very experienced banker in charge,” explains Stephen Grathwohl, a member of the bank board and a Connecticut commercial real estate developer and principal in Burr Street Equities. “The business is changing. As we get bigger, we are competing with other banks more often.”

In an industry increasingly driven by demographics, ShoreBank’s expansion strategy looks like the polar opposite of most other banks’. The company targets only communities that meet what Hasten calls the “mission criteria,” including median income and housing values that are below the medians for the entire Chicago metropolitan area. “We want to be in neighborhoods where lower-middle-class and poorer people live,” he explains.

Achieving the kind of growth directors envision will require additional capital. The board has already used M&A, paying $15 million in 2006 to acquire Greater Chicago Bank, a two-branch operation in the city’s western suburbs. That supplements previous de novo moves from its core South Side market into Chicago’s West and North sides. Additional deals will require currency, and even basic loan growth will mandate greater balance-sheet strength.

The company was recently in the midst of conducting a private placement, meaning directors could not comment further on capital-raising plans. But Hasten projects the company will have assets of $3.3 billion by the end of 2010, which implies a potential need for roughly $40 million in new capital to stick close to its present Tier 1 capital ratio of 9.51% of assets.

Complicating matters, some longtime investors are looking for an exit. The idea of replacing that capital is an especially touchy issue, due to fears that new investors’ expectations could somehow dilute the mission. “We want to give people some liquidity,” Grathwohl says. “But we don’t want [shareholders] coming in just looking at the profit side.” Directors discussed an initial public offering in 2006, but pulled back from the idea.

“[Investor relations] is a delicate issue,”Ludwig says. “This is fundamentally a do-gooder operation. One of the challenges is finding investors who are willing to sacrifice a bit on returns in exchange forthe certainty that the money will be used for social and environmental purposes.”

Hasten says having directors with top-flight national skill sets is extremely beneficial when it comes to navigating such challenges. Recently, Retsinas, the Harvard housing expert, helped management decipher complicated trends in the affordable housing rental market. “Instead of needing to figure it out on our own, we have one of the leading experts in the world on our board. Similarly, having a former comptroller on the board brings understanding and know-how to help work through the rocky regulatory environment.

“Too many times, banks put customers or visible community personages on the board to get more business,” Hasten says. “That used to be okay. The bar was lower in terms of the board’s guidance and oversight responsibilities. Today you need directors who might not drive as many revenues, but understand better how the businesses work.”

Shorebank’s origins trace back 40 years, with the seemingly lofty goal of creating an entirely new industry. The time was the late 1960s, and four idealistic young bankers were plugging away at the old Hyde Park Bank, where they had met with some success making loans to minority-owned small businesses. u00e2u20acu0153We were all looking for the next challenge. We felt that a lot of change was needed in banking, and that we could make it happen,”Houghton recalls.

Race riots broke out on Chicago’s West Side in 1968 following the assassination of Martin Luther King Jr., leaving the neighborhood a burned-out shell. The devastated housing stock accelerated a trend that had already seen blacks who could afford it moving to other parts of the city, filling in for whites who were fleeing to the suburbs.

The South Shore neighborhood witnessed some of the most breathtaking change. A mile-by-mile-and-a-half patch of land, just minutes from downtown, it was considered one of the city’s most prestigious locales in the 1940s and 1950s, boasting a lakeside country club and lagoons for sailboats. In 1960, the census showed its inhabitants were almost 100% white; a decade later, 70% of the residents were African-American. “Black families, like every other group ahead of them, were looking for better housing,”Grzywinski explains. “As they moved into South Shore, the white families moved out.”

The owners of the one bank with headquarters in the community, South Shore National Bank, didn’t take well to the change. Uncomfortable with the evolving demographics, they turned off the lending spigots”mortgage loans, for instance, suddenly required 50% down payments -and failed to accommodate the new residents two-wage-earner lifestyles with longer hours. The bank’s management applied with regulators to move the charter downtown, but was turned down. “Like a lot of bankers, they behaved in a hostile manner to the people who were moving in,” Grzywinski says. “Those people responded in kind and took their money out.” In just a few years, the deposit base had shrunk from $85 million to $37 million, says Taub, who wrote a book on ShoreBank’s history.

At the same time, Grzywinski was studying on a fellowship at the University of Chicago. His coursework involved building off of what he had learned as Hyde Park’s president to design a new kind of “self-sustaining community organization” that could fund development in “depressed economic areas.” He was particularly intrigued by a change to the Bank Holding Company Act approved by Congress in 1970 that defined investments in community development corporations as a “permissible” activity.

South Shore’s plight presented Grzywinski, Houghton, and two other cofounders -Milton Davis and James Fletcher- with the chance to put those theories into action. The group pooled its money, solicited a handful of other investors for a total of $800,000 in capital, and borrowed another $2.4 million. In 1973, they bought the company.

The initial plan was to focus on minority-owned small businesses, but that changed in the first week to originating conventional mortgages. “The immediate need was to rebuild neighborhood self-confidence,” Grzywinski says.

A second niche, financing rehabbers, quickly followed, and has since become ShoreBank’s signature product. While nice single-family homes still lined the Lake Michigan shore, about three-quarters of the population lived in 1920s-era, three-story multifamily walk-ups. u00e2u20acu0153Every other place in the city with this kind of housing stock had gone through disinvestment and demolition,” he says. “To me, it was a ticking time bomb.”

The good news was, South Shore’s decline wasn’t so far along that it couldn’t be reversed. Success brought outside attention. In the 1980s, then-Gov. Clinton solicited ShoreBank’s help to launch a development bank in rural Arkansas. It wasn’t easy. Many of the skills that worked in a big city -property valuation expertise, face-to-face meetings, and the whole housing focus -didn’t translate well to a sprawling rural area. “The emphasis was more on developing entrepreneurs,”Taub says. Nevertheless, that company, Southern Financial Partners, continues on today, though ShoreBank is no longer involved.

Soon, shareholders began pushing ShoreBank further out into the world. At the behest of the Ford Foundation, company officials advised Grameen’s Yunus in the 1980s on how to effectively manage a bank for low-income clients. Yunus has also consulted on some ShoreBank projects. In 2007, ShoreBank’s advising clients and investees loaned $940 million, almost all of it to small businesses and microbusinesses, in 35 countries around the world.

Houghton says ShoreBank’s experience has busted an unspoken myth that “African-Americans who are low- or moderate-income [wage-earners] will not repay their loans.” It’s also proven that a bank can turn profits doing labor-intensive smaller transactions in low- and moderate-income areas.

Perhaps the biggest challenge for the board is to hold true to the original mission while trying to add pieces to it. The company has incorporated conservation into its lending programs for about two decades, but it didn’t codify it as a core thrust until around 2000, when what had been a u00e2u20acu0153double bottom line” focused on financials and development officially got a third component.

The emphasis on environmental issues is most evident at ShoreBank Pacific. Launched in the mid-1990s, that unit, with less than $200 million in assets, employs an in-house underwriting program that scores borrowers on everything from the basics -turning off computers at night or using safer cleaning products- to more complex practices, such as whether they provide mass-transit passes to employees or utilize production with local goods and services.

Taub says the economic benefits are relatively easy to comprehend. Many of the bank’s clients operate on the Willapa Bay in southwestern Washington. “If you work to keep the bay there pristine, you can get some brand differentiation for the salmon and oysters that come from there and charge a premium price,” he says. The bank also gets much of its funding from so-called “eco-deposits” from conservation-minded individuals and organizations around the country.

When it comes to the Chicago bank, however, Taub argues that the environmental thrust looks a bit like u00e2u20acu0153mission creep,” and risks diluting the development mission. “It’s adding an extra dimension that I wouldn’t include,” Taub says. Hasten says he shared those concerns when he took the helm, but has since been persuaded of its value. “I’d be worried if we were financing green initiatives outside of our market,” he explains.

The Chicago bank scores all loans on such minutiae as the types of windows or light bulbs used, and often requires a free energy audit of a project or home before granting a loanu00e2u20ac”offering a free, energy-efficient refrigerator in exchange. At a time of growing concern about global warming and higher energy costs, such tactics are winners for all sides, Houghton says.

Clients can often pay down the cost of higher-priced, energy-efficient components in less than five years through the savings on gas and electric billsu00e2u20ac”and reduce their own emissions. u00e2u20acu0153Itu00e2u20acu2122s about economic self-interest,u00e2u20ac Houghton says. u00e2u20acu0153A bank can specialize in this area and gain a competitive advantage.u00e2u20ac

With the economy and environment both facing challenges, the obvious question is, why arenu00e2u20acu2122t there more lenders around the country mimicking ShoreBanku00e2u20acu2122s model? The answer, Garabedian says, comes down mostly to leadershipu00e2u20ac”from the founders and the board. u00e2u20acu0153It takes a passion for the mission at the top,u00e2u20ac he says. ShoreBanku00e2u20acu2122s board has that in spades.

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