If your duties include the management of your community bank’s investment portfolio, you have my undying respect. It’s hard enough to stay current on new products, regulatory expectations and viable strategies while, oh yeah, keeping an eye on the rest of the balance sheet. In the last seven years, you’ve also contended with generational-low interest rates in your quest to make the bond portfolio a profit center.
Given that your correspondent is a former bond salesman it may sound odd, if not heretical, for me to suggest that instead of buying bonds you consider the sale of certain assets to achieve your community bank’s financial goals. Many hundreds of community banks have taken advantage of this opportunity, and yours can too.
The Small Business Administration (SBA) helps create commerce by guaranteeing portions of certain loans made to qualifying borrowers. The platform with the greatest volume, which not coincidentally is the one that produces the most fee revenue to the lender, is the 7(a) program. In the first nine months of fiscal year 2015, 45,000 loans worth $16.2 billion were closed nationwide. Both figures represent a 20 percent increase over 2014.
It has been well documented that a solid majority of loans made to small business are originated by community banks. Most banks, it may surprise you to learn, close just a few loans each year, but still are able to produce a significant portion of their organization’s net income. Some estimates are that the average 7(a) participant originates less than 20 loans per year.
Fee income, anyone?
The motivations for many SBA lenders are simple, and twofold. The first is that SBA borrowers are incremental commercial loan customers. Most of them for one reason or another do not qualify for conventional financing, which doesn’t necessarily mean they are a poor credit risk. So loan growth, which is often cited by community bankers as a priority, can be achieved by off-the-grid lending.
Now for the good stuff. It is relatively common for a new SBA loan to have a market value of over 110 cents on the dollar. There are “conditions” that need to be in place for this to happen, but a properly structured loan can fetch a price of 114.00 or more. Conditions include no seasoning, reset dates on calendar month or quarter end, indexing to the Prime Rate, and no caps or floors. Be aware that any amount over 110 has to be shared evenly with the SBA, but that is no reason to avoid this opportunity.
Why, you may ask, does anyone pay this much for an instrument that can pay off at any time? Such is the magic of the secondary market, and of the pooling process. There are about 12 firms in the United States that actively make a market in purchasing SBA loans from the originators (mainly community banks), but that’s really a means to an end.
The “poolers” will aggregate these loans and issue a full faith and credit instrument against them. Banks and other depositories buy the pools as money-market alternatives that will do a great job of beating overnight rates, and even two- to three-year Treasury yields, with much less price volatility. The end buyers, which can include your own community bank, are willing to buy these securities that have 10- to 15-point premiums because the prepayment risk is greatly dispersed through the aggregation process.
For example, let’s examine an SBA pool with 33 loans, which is a moderate loan count. If one of the loans in the pool prepays or defaults early, the investor will receive the pro-rata principal back at 100 cents on the dollar. While this can cause the yield to decline as the premium attached to that loan must be immediately amortized, the fact that there are 33 loans in the pool means that on average an early prepayment of one loan will only result in about 3 percent of the security being liquidated.
So, the objective of this column is to encourage you and your lending associates to participate early and often in the SBA secondary market. Many community banks treat their SBA activities as a separate revenue center. The fee income potential is enough to make a bond broker forget what he’s here to sell.