Rufus Thomas, the late R&B impresario whose hit list included “The Funky Chicken” and “Walking the Dog,” was not known to be a market maker of Small Business Administration (SBA) 7(a) loans. It’s ironic, then, that he was talking about the two-sided benefits of both lending and investing in these products when he released his 1970 hit “Push and Pull.”
Hundreds of community banks have learned that this strategy can satisfy several needs on their balance sheets and income statements. The loan department makes quality loans, which are usually 75 percent guaranteed by the federal government, in many cases to borrowers that are outside the community bank’s traditional lending grid. The investment portfolio manager buys zero percent risk-weighted assets that are true floating rate instruments backed by these loans, at yields that far exceed other money-market alternatives. As Rufus himself might have said, “Let’s boogie!”
The 7(a) program has grown exponentially in the last four years as the economy has expanded and borrowers have improved their own balance sheets. In Fiscal Year 2017 the SBA estimates that there will be requests for $29 billion in guarantees, up from $17 billion in 2013.
The growth in the program has had no impact on the national debt. The 7(a) program is “zero subsidy,” meaning that the fees charged the borrowers cover the costs of administration. That is a major reason the government has gradually approved larger appropriations. Of course, supporting private enterprise has been a hallmark of community banking for generations.
These loans are almost all floating rate tied to the prime rate. Borrowers’ rates can range from 1.00% to 2.75 percent over prime, and loan terms will vary based on use of proceeds. Working capital credits can be seven- to ten-year terms, while real estate-backed loans can be as long as 25 years.
About half of these loans are sold into a lucrative secondary market. The lender/seller is required to retain servicing (with a 1.00 percent servicing fee), as well as the full unguaranteed portion. The sale of the loan is not visible to the small business owner since monthly payments continue to be made to the originating community bank.
Pick up the beat
The sale of the loans is really just a step in the procession. The reason a community bank is able to sell its guarantees at 10 percent premiums and higher is that there are ready buyers of the securities collateralized by these small business loans. A consortium of poolers buys the loans and aggregates them into groups of homogenous maturities, then issues Guaranteed Loan Pool Certificates (GLPCs) backed by the U. S. government.
GLPCs have some obvious and tangible benefits for community bank bond portfolios. As mentioned they’re floating rate, so the risk metric known as “effective duration” is very short. These securities are fairly liquid and pledgeable. They have monthly principal and interest cash flow which further helps manage interest rate risk. Finally, the yields for these have been near that of a three-year Treasury note, in spite of their (usually) quarterly reset window.
Let’s walk our way through an example. Currently, 10-year prime plus 2.00 percent loans can be sold to a pooler at a price of about 108.50. You, the lender/seller, would keep the 25 percent unguaranteed portion, and you would retain 1.00 percent of the guaranteed balance as servicing income. (Longer loans and those with higher note rates will have higher prices.) The premium represents gain recognized immediately on sale date.
Once an aggregator has accumulated enough 10-year loans to issue a security, it will do so at a price of about 109.00. (SBA requires a pool to have at least 4 loans and a face of at least $1 million, although most securities have a multiple of both.) The investor assumes one major risk: that the loans behind the pool prepay sooner than expected. This is why it’s vitally important for the buyer to examine detailed loan listings made available by the pooler, which is effectively the DNA. Generally, these investments will produce a yield that is about 100 basis points (1.00 percent) above the effective fed funds rate.
This column barely scratches the surface of this subject. It is significant, though, that the number and dollar amount of 7(a) loans being made, and the number of community banks that own GLPCs, have skyrocketed in the last decade. That is argument enough of the benefits seen by the thousands of participants in the push and pull of this two-way market.
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