Small Business Administration: Size of the SBA 7(a) Secondary Markets is
Driven by Benefits Provided (Letter Report, 05/26/99, GAO/GGD-99-64).

Pursuant to a congressional request, GAO provided information on the
secondary markets for 7(a) small business loans guaranteed by the Small
Business Administration (SBA), focusing on: (1) the benefits and risks
of secondary loan markets to participants; (2) primary benefits and
risks to participants in the guaranteed 7(a) secondary market and the
unguaranteed 7(a) secondary market; and (3) a comparison of the
guaranteed 7(a) secondary market with the secondary market for federally
guaranteed residential mortgages, and the unguaranteed 7(a) secondary
market with the secondary market for residential mortgages without a
federal guarantee.

GAO noted that: (1) the proportion of loans that are sold in a secondary
market depends on the benefits generated by the secondary market and how
the benefits and risks are distributed among market participants; (2) by
linking borrowers and lenders to national capital markets, secondary
markets benefit lenders, borrowers, and investors; (3) these markets:
(a) tap additional sources of funds; (b) reduce dependence on
availability of local funds; (c) help to lower interest rates paid by
borrowers; and (d) help lenders manage risks; (4) they provide lenders a
funding alternative to deposits and, by enhancing market liquidity, they
can reduce regional imbalances in loanable funds; (5) secondary loan
markets can benefit borrowers by increasing the overall availability of
credit in the primary market and by lowering the interest rates
borrowers pay on loans; (6) the secondary markets in 7(a) loans provide
lenders a funding source that otherwise would not be available; (7) in
calendar year 1997, 1,540 SBA lenders sold 12,164 SBA 7(a) loans in the
guaranteed secondary market, generating $2.7 billion in sales of
guaranteed portions; (8) about $290 million in sales of unguaranteed
portions were made that year by a smaller number of lenders; (9) these
were generally Small Business Lending Companies, which lack a deposit
base, or banks that had not developed a sufficient deposit base as a
funding source for their loans; (10) lenders participating in these
markets can reduce funding costs, and investors in 7(a) pool
certificates and securities can get greater liquidity and lower risk
than they would from directly investing in individual loans; (11) in the
guaranteed 7(a) market, investors face prepayment risk, and in the
unguaranteed 7(a) secondary market, investors and lenders share
prepayment and credit risk; (12) both 7(a) secondary markets can help
lenders make more loans, which could contribute to a concentration of
SBA's credit risk among a few lenders that originate a large percentage
of 7(a) loans; (13) compared to the secondary markets for 7(a) loans,
the secondary markets for residential mortgages operate with greater
incentives for lenders to sell the loans they originate; (14) in 1997,
about 45 percent of the guaranteed portions of 7(a) loans originated
that year were pooled and sold on the secondary market compared to
virtually all federally insured single-family residential mortgages; and
(15) about 11 percent of the unguaranteed portions of 7(a) loans
originated in 1997 were pooled and sold on the secondary market compared
to about 32 percent of nonconforming residential mortgages.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-99-64
     TITLE:  Small Business Administration: Size of the SBA 7(a)
	     Secondary Markets is Driven by Benefits Provided
      DATE:  05/26/99
   SUBJECT:  Small business loans
	     Government guaranteed loans
	     Lending institutions
	     Mortgage loans
	     Mortgage programs
	     Comparative analysis
	     Mortgage-backed securities
	     Risk management
IDENTIFIER:  SBA 7(a) Loan Program

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Small Business Administration: Size of the SBA 7(a) Secondary
Markets is Driven by Benefits Provided (GAO/GGD-99-64) Small
Business Administration

Size of the SBA 7( a) Secondary Markets is Driven by Benefits
Provided

United States General Accounting Office

GAO Report to the Subcommittee on Government Programs and
Oversight,

Committee on Small Business, House of Representatives

May 1999 

GAO/GGD-99-64

May 1999   GAO/GGD-99-64

United States General Accounting Office Washington, D. C. 20548

General Government Division

B-278635

Page 1 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

GAO May 26, 1999 The Honorable Roscoe G. Bartlett Chairman,
Government Programs

and Oversight Subcommittee House Committee on Small Business House
of Representatives

Dear Mr. Chairman: As you requested, this report discusses the
secondary markets for small business loans guaranteed by the Small
Business Administration (SBA); these loans are known as SBA 7( a)
loans. The guarantee obligates SBA to repay a participating lender
a specific portion of the amount of the 7( a) loan (generally
between 75 and 80 percent) in the event of borrower default. The
secondary markets allow lenders to sell 7( a) loans they originate
and thus obtain funds for further lending. In most such
transactions, the 7( a) loans are pooled and sold to investors as
tradable financial claims on the cash flows that the pools
generate. This pooling of loans is an innovation widely applied in
the secondary markets for residential mortgage loans, where whole
loans are pooled to create tradable financial claims in the form
of mortgage- backed securities (MBS). SBA 7( a) loans are divided
into guaranteed and unguaranteed portions, and these are pooled
and sold in two separate secondary markets. Cash flows from pools
of guaranteed portions are used to back 7( a) pool certificates,
which are sold in the guaranteed 7( a) secondary market; cash
flows from pools of unguaranteed portions are used to back 7( a)
pool securities, which are sold in the unguaranteed 7( a)
secondary market.

As agreed with your office, the objectives of this report are to
(1) discuss the benefits and risks of secondary loan markets to
participants; (2) identify primary benefits and risks to
participants in the guaranteed 7( a) secondary market and the
unguaranteed 7( a) secondary market; and (3) compare the
guaranteed 7( a) secondary market with the secondary market for
federally guaranteed residential mortgages, and the unguaranteed
7( a) secondary market with the secondary market for residential
mortgages without a federal guarantee. We identified these
residential mortgage markets as the most valid comparisons for
these objectives.

The proportion of loans that are sold in a secondary market
depends on the benefits generated by that secondary market and how
the benefits and risks are distributed among market participants.
By linking borrowers and lenders to national capital markets,
secondary markets benefit lenders, Results in Brief

B-278635 Page 2 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

borrowers, and investors. These markets (1) tap additional sources
of funds, (2) reduce dependence on availability of local funds,
(3) help to lower interest rates paid by borrowers, and (4) help
lenders manage risks. They provide lenders a funding alternative
to deposits and, by enhancing market liquidity, 1 they can reduce
regional imbalances in loanable funds. Secondary loan markets can
benefit borrowers by increasing the overall availability of credit
in the primary market and, through competition among lenders, by
lowering the interest rates borrowers pay on loans. Investors in
secondary loan markets can benefit from greater liquidity and
lower risk than they would get by directly investing in individual
loans. Secondary loan market transactions also involve risks that
may be borne by the investor or distributed among various market
participants.

The secondary markets in 7( a) loans provide lenders a funding
source that otherwise would not be available. In calendar year
1997, 1,540 SBA lenders sold 12,164 SBA 7( a) loans in the
guaranteed secondary market, generating $2.7 billion in sales of
guaranteed portions. About $290 million in sales of unguaranteed
portions were made that year by a smaller number of lenders. These
were generally Small Business Lending Companies (SBLC), which lack
a deposit base, or banks that had not developed a sufficient
deposit base as a funding source for their loans. 2 Lenders
participating in these markets can reduce funding costs, and
investors in 7( a) pool certificates and securities can get
greater liquidity and lower risk than they would from directly
investing in individual loans.

In the guaranteed 7( a) market, investors face prepayment risk, 3
and in the unguaranteed 7( a) secondary market, investors and
lenders share prepayment and credit risk. 4 Both 7( a) secondary
markets can help lenders make more loans, which could contribute
to a concentration of SBA's credit risk among a few lenders that
originate a large percentage of 7( a) loans. In this environment,
a sharp increase in defaults, or the failure of one such lender,
could be costly to SBA. 5

1 A market is more liquid if market participants can buy and sell
large amounts of holdings without affecting the prices of traded
securities. 2 Nondepository lenders, which include SBLCs, were
authorized to sell unguaranteed portions in 1992; depository
institutions were not authorized to sell unguaranteed portions of
7( a) loans until April 1997. 3 Prepayment risk is the potential
loss of anticipated future income that results from borrowers
paying off their loans earlier than expected. 4 Credit risk is the
risk of financial loss due to borrower default.

5 Our 1998 report, Small Business Administration: Few Reviews of
Guaranteed Lenders Have Been Conducted (GAO/GGD-98-85, June 11,
1998), found that SBA had conducted few on- site reviews of its

B-278635 Page 3 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Compared to the secondary markets for 7( a) loans, the secondary
markets for residential mortgages operate with greater incentives
for lenders to sell the loans they originate. In 1997, about 45
percent of the guaranteed portions of 7( a) loans originated that
year were pooled and sold on the secondary market compared to
virtually all federally insured single- family residential
mortgages. About 11 percent of the unguaranteed portions of 7( a)
loans originated in 1997 were pooled and sold on the secondary
market compared to about 32 percent of nonconforming residential
mortgages. Notable factors affecting these proportions include the
relative (1) preponderance of fixed interest rates in the
residential mortgage market, (2) homogeneity of loan
characteristics among loans contained in each mortgage pool, and
(3) ability of residential mortgage market investors to evaluate
the risks associated with each loan pool based on data available
to them. Both 7( a) secondary markets lack certain attributes that
permit reasonably reliable statistical risk analysis, such as
relevant historical data on loan performance and loan homogeneity.
Although SBA could undertake actions or policy changes to increase
or improve the information provided to investors, such changes
could help some 7( a) borrowers and lenders, while others could be
adversely affected.

Authorized under section 7( a) of the Small Business Act (15 U. S.
C.  636 (a)), the SBA 7( a) program was established to serve small
business borrowers that cannot otherwise obtain private sector
financing under suitable terms and conditions. The SBA 7( a)
program is SBA's primary vehicle for providing small businesses
with access to credit, whereby SBA provides partial guarantees of
loans made by SBA- approved private sector lenders. One
requirement to obtain a 7( a) loan guarantee, which is backed by
the full faith and credit of the U. S. government, is that a
lender must document that the prospective borrower was unable to
obtain financing under reasonable terms and conditions through
normal business channels. SBA authorized secondary markets in 7(
a) loans to help lenders manage their funding needs for these
loans.

The SBA guarantee encourages lenders to make small business loans
by transferring most of an approved loan's credit risk from the
loan originator to SBA. The SBA guarantee eliminates credit risk
not only for the lenders on the guaranteed portion of 7( a) loans
but also for the investor in 7( a)

preferred lenders, indicating that SBA lacked sufficient lender
oversight to limit credit risk to the agency, including risk from
lender concentration. In commenting on a draft of this report, SBA
stated that it has taken significant steps to improve the
oversight of participating lenders, including SBLCs. We have not
evaluated these initiatives, but they appear to be the type of
actions that could mitigate credit risk to the agency resulting
from lender concentration. Background

B-278635 Page 4 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

pool certificates. In addition to the full faith and credit of the
U. S. government, the 7( a) pool certificates also carry SBA's
timely payment guarantee, which ensures that investors will be
paid on scheduled dates when collections from borrowers are not
timely. 6

SBA 7( a) loans are heterogeneous in that they differ in many
respects, such as interest rates; repayment schedules; maturity;
loan collateral type, quality, and marketability; and type of
business to which the loans are made. SBA 7( a) loans are made to
a diverse range of small businesses with widely differing
financial profiles and credit needs, such as restaurants, consumer
services, professional services, and retail outlets.

The dollar volume of 7( a) loans that SBA can guarantee each year
is based on congressional appropriations that subsidize the 7( a)
guarantee program. For the fiscal year that ended September 30,
1997, SBA approved nearly $9.5 billion in loans-- the highest
amount to date, and an increase of over 20 percent from the
previous fiscal year. As of December 31, 1997, there was $21.5
billion in outstanding 7( a) loans.

According to SBA, about 8,000 lenders are authorized to
participate in the 7( a) loan program. They range from
institutions that make a few 7( a) loans annually to more active
institutions that originate hundreds of 7( a) loans annually. Most
are insured depository institutions, such as banks and savings and
loan associations. Nondepository lenders include Business and
Industrial Development Companies, chartered under state statutes;
insurance companies; and SBLCs 7 licensed and regulated by SBA. At
the end of 1997, SBLCs accounted for about 19 percent of
outstanding 7( a) loans. SBA has established three classifications
of lenders within the 7( a) program-- regular, certified, and
preferred-- each having different levels of authority in
processing loans. SBA completely analyzes regular lenders' loans
and decides on their guarantee. The agency authorizes certified
lenders to perform their own credit analyses and preferred lenders
to make eligibility and creditworthiness determinations as well as
approve their own loans without SBA review.

SBA 7( a) loans differ from other small business loans in some
respects. Our 1996 report indicated that 7( a) loans tend to be
larger, have longer maturities, and have higher interest rates
than small business loans in

6 Individual 7( a) loans sold in the secondary market carry the
SBA guarantee but do not carry a timely payment guarantee. 7 A
moratorium on licensing new SBLCs has been in effect since January
1982.

B-278635 Page 5 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

general. 8 Typically, loans with features such as longer terms and
no prepayment penalties warrant higher interest rates. SBA figures
showed the average maturity of 7( a) loans sold in the secondary
market in 1997 was three times longer than for conventional
commercial and industrial loans under $1 million. Also, average
interest rates for SBA loans were 67 basis points 9 higher for
fixed- rate loans, and 178 basis points higher for variable rate
loans, than for respective categories of conventional commercial
and industrial loans under $1 million.

In the primary market, single- family residential mortgages differ
from 7( a) loans in a number of dimensions that directly affect
their respective secondary markets. A majority of residential
mortgages have fixed interest rates, and those with adjustable
rates have interest rate caps that limit interest rate risk to
borrowers. In contrast, 7( a) loans consist primarily of variable
rate loans without interest rate caps. As a result, lenders face
more interest rate risk 10 on residential mortgages than on 7( a)
loans. Residential mortgage loans are more homogeneous than 7( a)
loans because the terms are standardized, and collateral,
residential property, is the same.

In order to provide a perspective of how the 7( a) markets compare
with other secondary markets, we compared the two secondary
markets in 7( a) loan portions to the secondary markets for
single- family residential mortgages as follows:

 The secondary market for single- family residential mortgages
which has federal mortgage insurance provided by the Federal
Housing Administration (FHA), a government corporation within the
Department of Housing and Urban Development (HUD). These mortgages
are fully insured in the event of borrower default. Lenders who
originate FHAinsured mortgages can pool them and issue MBS
guaranteed by the Government National Mortgage Association (Ginnie
Mae), another government corporation within HUD, which, for a fee,
guarantees timely payment of principal and interest to investors.
We compared this secondary market 11 to the guaranteed 7( a)
secondary market.

8 Small Business: A Comparison of SBA's 7( a) Loans and Borrowers
With Other Loans and Borrowers (GAO/RCED-96-222, Sept. 20, 1996).
9 A basis point is one one- hundredth of a percentage point.

10 Interest rate risk is the risk of financial loss due to changes
in market interest rates. 11 A similar secondary market exists for
conventional single- family residential mortgages, which have no
federal mortgage insurance. Lenders who originate conventional
mortgages below a statutory

B-278635 Page 6 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

 The secondary market in conventional, single- family residential
mortgages that have loan amounts, or other characteristics that
preclude purchase by Fannie Mae or Freddie Mac. These are called
nonconforming mortgage loans. In this secondary market, state-
chartered private corporations- referred to as private- label
conduits-- pool mortgages they purchase and issue MBS. We compare
features of this market to the unguaranteed 7( a) loan secondary
market.

The benefit to individual lenders of selling loans in a secondary
market depends in part on demand for that lender's loans and
availability and costs of the lender's alternative funding
sources. Other considerations include whether holding loans on the
balance sheet or selling them in the secondary market brings
higher returns on invested capital and/ or lowers the lender's
risks.

To meet our report objectives, we reviewed SBA's standard
operating procedures for the 7( a) program and other SBA documents
addressing the role of the secondary markets for 7( a) loans. 12
We also reviewed research conducted by SBA, HUD, other federal
agencies, and others on the workings of the 7( a) markets;
secondary markets for conventional small business loans; and
residential mortgage loan secondary markets. We analyzed data on
the 7( a) program from SBA as well as publicly available
information on the residential mortgage market. We also talked to
SBA officials and officials of its fiscal and transfer agent,
Colson Services, Corp.; Ginnie Mae; HUD; the National Association
of Government Guaranteed Lenders; the Bond Market Association; the
American Bankers Association; the Independent Bankers Association;
participating 7( a) lenders and poolers; other participants in the
small business loan markets; the Office of Federal Housing
Enterprise Oversight (OFHEO); the Board of Governors of the
Federal Reserve System; the Office of the Comptroller of the
Currency; and the Securities and Exchange Commission (SEC).

To meet our third objective, we analyzed the secondary market in
residential mortgages to determine which parts of that market to
use for

dollar level can sell them to the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac), two private corporations with federal
charters. These two corporations are called government- sponsored
enterprises (the enterprises) and with a majority of their
mortgage purchases, they pool the mortgages and issue MBS backed
by these loans. These enterprises normally provide corporate
guarantees on MBS they issue, which eliminate credit risk for MBS
investors. This secondary market has features that we compare to
the guaranteed and unguaranteed secondary markets in 7( a) loans.

12 The SBA documents we reviewed included SBA rulemaking efforts
directed at the unguaranteed secondary market for 7( a) securities
and the comments submitted during the course of SBA rulemaking
efforts. Scope and

Methodology

B-278635 Page 7 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

comparative purposes in this report. The secondary market in
residential mortgages is divided into three broad parts. The first
part is based on federally insured/ guaranteed mortgages provided
by FHA or the Department of Veterans Affairs (VA). In this market,
residential mortgage loans are pooled to create tradable financial
claims in the form of securities, with pool guarantees from Ginnie
Mae. A majority of mortgages backing Ginnie Mae MBS are FHA-
insured mortgages. We deemed this secondary market analogous to
the guaranteed 7( a) market for purposes of this report. A second
part of the secondary market is for mortgages that conform to
underwriting standards created by the enterprises. Although the
government does not guarantee these mortgages, the private sector
perceives the federal connections of the enterprises as providing
an implicit guarantee and takes into account their pool
guarantees. The last part of the secondary residential mortgage
markets includes nonconforming mortgages that are fully private
and pooled without implicit or explicit government guarantees. We
deemed this secondary market analogous to the unguaranteed 7( a)
secondary market for this report's purposes.

In our review of disclosures made to investors in guaranteed 7( a)
pool certificates, we relied on SBA regulations and information
obtained in discussions with SBA and Colson officials. For
unguaranteed pool securities, we reviewed offering statements from
an issuer of SECregistered, publicly offered 7( a) pool
securities, but we did not obtain offering statements or materials
for 7( a) pool certificates or 7( a) pool securities that were not
SEC registered. We used information from financial industry
publications, Ginnie Mae disclosure forms and offering statements
to determine financial disclosure information provided on the
various forms of MBS.

We conducted our work in Washington, D. C., between September 1997
and December 1998 in accordance with generally accepted government
auditing standards.

We provided copies of a draft of this report to SBA for review and
comment. SBA's Associate Deputy Administrator for Capital Access
provided written comments on the draft report, which are
summarized on page 34 and reprinted in appendix IV. SBA and Ginnie
Mae provided technical comments on the draft report, which have
been incorporated where appropriate.

B-278635 Page 8 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Secondary loan markets, which are resale markets for loans
originated in primary markets, link borrowers and lenders in local
markets to national capital markets, lower costs for funds, and
help lenders manage risks. This linkage provides an additional
source of funds for lenders that can increase lenders' liquidity.
Borrowers can benefit from the ensuing increase in funds
availability and from lower interest rates that result from lender
competition. Investors in secondary loan markets can benefit by
holding more liquid financial instruments than they would have
from investing directly in individual loans.

The major risks in secondary loan market transactions-- as well as
in primary market lending-- are credit, prepayment, and interest
rate risks. Investors, guarantors, and lending institutions that
securitize loan pools can suffer losses or incur costs as a result
of one or more of these risks in the secondary markets. The levels
and types of risk, as well as the parties that incur risk, can
differ as well. These variables are important determinants of the
share of loans in a particular primary market that are sold in
secondary markets. Factors bearing on individual lenders'
decisions to sell their loans in a secondary market include loan
demand, the availability and costs of alternative funding sources,
and the relative risks or returns from selling loans on the
secondary market compared to holding them. The share of loans in a
primary market that are sold in a secondary market depends on the
benefits generated by the secondary market.

Secondary loan markets can generate a number of benefits for
lenders and borrowers. The secondary loan markets provide an
alternative funding source in addition to deposits and other
funding sources, such as lines of credit and debt issuance
proceeds. Selling their loans on the secondary markets provides
lenders more flexibility in managing their liquidity needs. They
can generate funds for additional lending, earn fee income by
servicing the sold loans, 13 or avoid tying up capital. The
resulting liquidity can reduce regional imbalances or cyclical
swings in loanable funds. Borrowers can benefit from increased
credit availability, and competition among lenders can provide
borrowers with lower interest rates. By investing in pools of
loans, investors can diversify their risks among a number of loans
rather than having them concentrated in one loan. Investors can
sell their interests on active secondary markets to other willing
investors.

13 Lenders service the types of loans discussed in this report by
collecting payments from borrowers and making scheduled payments
to investors, as well as meeting requirements when borrower
payments are late or defaults occur. Secondary Loan

Markets Generate Benefits and Concerns

Lenders, Borrowers, and Investors Can Benefit From Secondary Loan
Markets

B-278635 Page 9 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

The primary risks that can affect the cash flows generated by loan
pools in secondary loan markets are credit, prepayment, and
interest rate risks. A variety of factors affect the levels of
these risks in secondary loan market transactions as well as the
parties that incur them, as illustrated by the following general
observations:

 Credit risk levels depend upon characteristics of the pooled
loans that back a security, such as borrowers' credit worthiness,
the collateral securing the loans, the type of business financed,
and the pool's geographic diversity.

 The federal government-- and therefore U. S. taxpayers-- bears
the credit risk on securities backed by pooled loans with federal
guarantees.

 The investor and the lender share credit risk on securities with
credit enhancements 14 provided by the lender.

 The level of prepayment risk in a security depends, in part, on
whether prepayment penalties are included on the pooled loans
backing a security.

 The nature of the interest rates on loans-- fixed or variable--
affects the level of interest rate risk.

Since the inherent credit, prepayment, and interest rate risks are
important to investors, the ability to estimate returns and risks
of securitized loan pools is also important.

14 A credit enhancement is a payment support feature that covers
defaults and losses up to a specific amount on loans backing a
security, thereby reducing investor need for loan- specific
information. It acts to increase the likelihood that investors
will receive interest and principal payments in the event that
full payment is not received on the underlying loans. Credit,
Prepayment, and

Interest Rate Risks Are Primary Risks in Secondary Loan Markets

B-278635 Page 10 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Reliable estimates of returns and risks are more likely when
historical data on the performance of similar loans under varying
economic conditions are available and when loan pools are
homogeneous. When historical data include the loss experience of
many comparable loans under a wide variety of economic conditions,
investors and analysts can calculate loss probability
distributions that predict the likely losses for a pool of similar
and homogeneous loans. However, the less alike the loans are, the
more troublesome it can be to estimate cash flows or the
likelihood of losses. Although more precise cash flow estimates
improve investors' ability to estimate or measure risk, they may
also lower returns because investors want to be compensated
according to the degree of risk they undertake. Therefore, when
less precise estimates can be made, both risks and returns to
investors are generally higher. Monetary benefits to lenders from
participating in the secondary market lessen when they must pay
investors high returns.

As discussed earlier, secondary loan markets give lenders a
funding alternative to deposits and other funding sources, such as
lines of credit and the proceeds from debt issuances. The benefit
to an individual lender of selling loans in a secondary market
depends in part on the comparative costs of its available funding
sources. For example, a lender that has access to adequate funding
to meet the demand for loans, consistent with its business plan,
may lack funding- related incentives to participate in secondary
loan markets. The benefit of secondary markets to individual
lenders also depends on whether holding loans on the balance sheet
or selling them in the secondary market can best increase returns
on invested capital and/ or lower risks for the lender. For
example, a financial institution holding long- term fixed rate
loans financed by variable rate liabilities is subject to interest
rate risk, which the institution could reduce by selling these
loans on the secondary market.

In linking 7( a) borrowers and lenders from local markets to the
national capital markets, the 7( a) secondary markets--
particularly the market for guaranteed portions-- benefit lenders,
borrowers, and investors. The 7( a) secondary markets can help
borrowers and lenders by reducing regional imbalances and cyclical
swings in credit availability and pricing. In 1997, the guaranteed
7( a) secondary market served as a funding source for many
Secondary Loan Market

Benefits to Individual Lenders Depend on Several Factors

The Secondary Markets in SBA 7( a) Loans Generate Benefits and
Risks

B-278635 Page 11 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

lenders, particularly for about 50 institutions that generally
lacked deposit bases, according to an SBA official. The 7( a)
secondary markets can also help qualified borrowers by providing a
means to lower interest rates or to make 7( a) loans available at
more favorable terms. Institutional investors in 7( a) pool
certificates and securities-- including pension funds, mutual
funds, insurance companies, and others-- benefit from the greater
liquidity and lower risks in pool certificates and securities
compared to investments in individual loans. Figure 1 illustrates
differences in how the guaranteed and unguaranteed markets work.

B-278635 Page 12 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Figure 1: The 7( a) Loan Pooling Process

B-278635 Page 13 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Source: SBA.

Investors, poolers, lenders, and SBA face various risks from the
7( a) secondary markets. 15 Investors in the guaranteed 7( a)
market face prepayment risk, and investors and lenders in the
unguaranteed 7( a) secondary market share prepayment and credit
risks. The heterogeneity of 7( a) loans makes estimation of risks
difficult for investors and limits the overall benefits of the
secondary markets. Another limiting factor is the fact that
interest rate risk in the 7( a) markets is less because most 7( a)
loans have variable interest rates pegged to current prime market
rates. Interest rate risk is less likely to be a factor for most
depositories because few 7( a) loans have fixed interest rates.

15 Because most 7( a) loans have variable interest rates without
interest rate caps, we do not discuss interest rate risk here.

B-278635 Page 14 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

SBA faces the possibility of a concentration of credit risk from
both 7( a) secondary markets. The combination of the potentially
large amount of funds and economies of scale that individual
lenders may achieve by increasing the number of 7( a) loans they
sell could result in a concentration of 7( a) loans serviced by
one or a few lenders. A sharp increase in loan defaults by, or the
failure of, one such lender could be costly to SBA, which lacks
controls for concentration risk. Moreover, our 1998 report 16
cited inadequacies in SBA's efforts to ensure sound SBLC lending
practices. While the participation of rating agencies in the
unguaranteed marketplace encourages lenders to follow prudent
lending practices, this factor alone may not adequately limit
SBA's credit risk from lender concentration. Although high ratings
on securities backed by unguaranteed portions of 7( a) loans may
indicate that lenders have followed prudent lending practices,
lenders may be able to change these practices and operate for some
time before the ratings are lowered to reflect the change, thus
some credit risk from lender concentration remains.

In calendar year 1997, 1,540 SBA lenders sold 12, 164 7( a) loans
(about 45 percent of the 7( a) loans approved during the most
recent fiscal year) in the guaranteed secondary market and
collectively generated $2.7 billion in sales. About 50 of those
lenders used the guaranteed 7( a) market extensively, selling
every 7( a) loan they originated, according to an SBA official.
These lenders generally lacked a sufficient deposit base to fund
their loans.

The unguaranteed 7( a) secondary market is much smaller than the
guaranteed 7( a) market. At the end of 1997, the total guaranteed
portions of outstanding 7( a) loans was $10 billion. Only nine 7(
a) lenders six nondepository lenders and three depository lenders
had securitized 20 pools of unguaranteed portions of 7( a) loans.
One of these lenders, The Money Store, was responsible for 8 of
the transactions, which accounted for about two- thirds of the
total $1.25 billion in unguaranteed portions securitized since
1992.

In 1992 , SBA authorized the creation of the unguaranteed
secondary market as a funding source for nondepository
institutions. Since that time, these lenders have been able to
sell pools of unguaranteed portions of their 7( a) loans in the
secondary market. In 1996, Congress mandated that SBA revise its
rules to allow all lenders to sell the unguaranteed portions of
their 7( a) loans on the secondary market. In April 1997, SBA

16 GAO/GGD-98-85, June 11, 1998. The 7( a) Secondary Markets

Generate Benefits for Many Depository and Nondepository
Institutions

Only Nondepository Lenders Were Authorized to Sell Unguaranteed
Portions of 7( a) Loans in the Secondary Market From 1992 Through
1996

B-278635 Page 15 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

promulgated an interim rule that extended the provisions of the
previous rule to include all participating 7( a) lenders. Under
the interim rule, SBA was to review each proposed securitization
on a case- by- case basis for safety and soundness concerns. The
interim rule remained in effect until April 12, 1999, when SBA's
final rule, promulgated February 10, 1999, became effective.

The unguaranteed 7( a) secondary market comprises buyers and
sellers of securities backed by the unguaranteed portions of 7( a)
loans. Securities backed by unguaranteed portions of 7( a) loan
portions can be issued and sold to investors in either public
offerings or private placements. Unlike certificates backed by
guaranteed portions of 7( a) loans, the public sale of these
securities is subject to SEC registration and disclosure
requirements. The Securities Act of 1933 requires that securities
sold in a public offering be registered with SEC before they are
distributed and that certain information regarding the securities
and the issuer of the securities must be disclosed to prospective
buyers. 17 Issuers can avoid the costly registration and reporting
process required of public offerings by offering the securities in
private placements. Private placements must be made on a limited
basis to selected persons, and not be part of a general public
solicitation. In general, private placements are less liquid than
publicly traded securities. Eight of the 20 pools of unguaranteed
portions of 7( a) loans were sold in public offerings.

Securities backed by unguaranteed portions generally carry one or
more credit enhancements to raise the ratings of these securities
and attract investors. As of December 31, 1998, the senior class
of all 20 securitizations of unguaranteed portions had investment
grade ratings.

Although constrained by annual congressional appropriations for
the 7( a) loan program, the 7( a) secondary markets can benefit
borrowers of program loans by making loans available at more
favorable terms, as other secondary markets do. Lenders that
profit from the secondary markets may pass on some of their gains
from lower funding costs to borrowers in the form of lower
interest rates. Growth in SBA's lending authority has accelerated
since 1985, when SBA first allowed lenders to pool guaranteed
portions of 7( a) loans for secondary market sales. SBA's annual
7( a) loan volume grew steadily from $2.3 billion in fiscal year
1985 to $3.1 billion in fiscal year 1991, and $9.5 billion in
fiscal year 1997.

17 The Securities Exchange Act of 1934 requires continuing
disclosure after a security is issued. Borrowers Benefit From the

7( a) Secondary Markets

B-278635 Page 16 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Secondary markets for investments backed by SBA 7( a) loan pools
attract a wide range of institutional investors, including pension
funds, mutual funds, insurance companies, and others that might
not otherwise consider investing in small business loans.
Investors in 7( a) pool certificates and securities benefit from
greater liquidity and lower risks than they would get from
investing directly in individual loans, because these instruments
can be sold more easily than individual loans, and risks are
dispersed among the pooled loans.

Investors in guaranteed portions do not face credit risk because
the SBA guarantee transfers that risk from the investor to SBA.
Investors who purchase 7( a) pool securities backed by
unguaranteed portions face both credit and prepayment risks. They
typically share the credit risk with the lender. That is, SBA 7(
a) pool securities typically carry one or more forms of lender-
provided credit enhancement, which reduces credit risk and makes
the securities more attractive to investors. The most common form
of credit enhancement uses excess spread, 18 which is a cash
reserve funded by a portion of collections from borrowers' loan
payments on guaranteed and unguaranteed portions of the loans.
Another common form of credit enhancement used with securities
backed by unguaranteed portions is subordination. In
subordination, at least two classes of security are created, with
the subordinate classes subject to absorbing a prescribed amount
of losses on the loans backing the securities. Credit enhancements
provide funds to maintain scheduled payments to investors if
borrowers go into default or are late in making payments. Such
enhancements are required by credit rating agencies to bring
securities to investment- grade ratings, as they act to mitigate
credit risk. Providing such loss protection comes at a cost to the
lender. The higher the credit enhancement needed to sell the
securities, the lower the net proceeds to the lender from the sale
of the securities and therefore the incentive to securitize the
loans.

Investors and analysts can generally make more reliable estimates
of the returns and risks of loan pools when they are homogeneous
and when historical data are available on the performance of
similar loans under varying economic conditions. The availability
of large bases of historical data that include the loss experience
of many comparable loans can enable

18 Excess spread is the difference, after expenses, between
scheduled collections from borrowers whose loans are in a
particular pool and scheduled payments to investors in the
certificates or securities that are backed by the pool. It is
stated as a percentage of the total amount of the loans in the
pool. For example, a spread of 1 percent could mean that scheduled
collections from borrowers reflect an aggregate interest rate of 8
percent, and scheduled payments to investors reflect an investment
yield of 7 percent. Investors Benefit From the

7( a) Secondary Markets Investors Purchasing Unguaranteed Portions
of 7( a) Loans Face Credit and Prepayment Risks

B-278635 Page 17 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

investors and analysts to estimate loss probability distributions
from those data and use the results to predict the expected loss
experience for a pool of similar and homogeneous loans. When
secondary market investors face high levels of credit risk or lack
information to estimate such risks, they demand greater credit
enhancements and yields. These factors act to lower the prices
investors will pay for securities backed by the unguaranteed
portion of 7( a) loans.

A discussion of how credit rating agencies determine ratings for
SBA loanbacked securitizations appears in appendix I.

To compensate for prepayment risk, investors demand higher yields
on 7( a) pool certificates than on Treasury securities with
comparable maturities. As with Treasury securities, the U. S.
government bears the credit risk on SBA pool certificates backed
by guaranteed portions of 7( a) loans, but it does not bear the
credit risk for securities backed by unguaranteed portions of 7(
a) loans. Therefore, excess spread from guaranteed certificates is
set aside to shoulder some of the credit risk burden associated
with the unguaranteed portions of 7( a) loans. This use of excess
spread as a credit enhancement affects the spread between the
interest rate the borrower pays and the rate paid to investors in
7( a) pool certificates.

To address prepayment concerns, the Bond Market Association has
proposed that SBA consider imposing prepayment penalties
structured to reduce borrower incentives to refinance 7( a) loans
as nonguaranteed commercial loans at marginally lower rates. While
flexibility for some borrowers would be constrained if prepayment
penalties were imposed, 7( a) loans with such prepayment penalties
could lead to more favorable loan terms for borrowers. Such a
feature in 7( a) loans, and often present in commercial business
loans, would also mean less prepayment risk for investors in the
7( a) secondary market.

A discussion of the mechanics of the guaranteed 7( a) secondary
market appears in appendix II. Investors in 7( a) Pool

Certificates Face Prepayment Risk

B-278635 Page 18 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

The 7( a) secondary markets could also be instrumental in
contributing to a concentration of credit risk for SBA. Because
SBA generally guarantees 75 to 80 percent of each 7( a) loan, the
failure of one or more large lenders to follow prudent lending
practices necessary for making creditworthy loans can expose SBA
to credit risk once those loans go into default. As a large
potential funding source for lenders, the 7( a) secondary markets
can enable lenders active in the secondary markets to increase
loan volume, and the existence of economies of scale could
possibly lead to concentration of the 7( a) portfolio among a few
lenders.

Through the rating process, the marketplace encourages lenders to
follow prudent lending practices and provide credit enhancements
that will protect investors to a certain degree. However, this
alone may not provide sufficient lender discipline to limit credit
risk to SBA resulting from concentration of 7( a) loans in the
servicing portfolio of a large lender that does not follow prudent
lending practices. Although high ratings on securities backed by
unguaranteed portions of 7( a) loans may indicate that lenders
have followed prudent lending practices, lenders may be able to
change these practices and operate for some time before the
ratings are lowered to reflect the change, thus some credit risk
from lender concentration remains.

Our 1998 report 19 noted that weaknesses existed in regulatory
oversight to help ensure that the 7( a) lenders comply with
requirements that mitigate SBA's credit risk. It stated that SBA
had established various lender standards and loan policies and
procedures to help ensure that lenders follow prudent lending
standards. However, the report noted, without conducting periodic,
on- site lender reviews, SBA had no systematic means to help
ensure that lenders' actions did not render loans ineligible,
uncreditworthy, or uncollectible, and thus increased the risk of
loss to the agency. Although financial institution regulators help
ensure safe and sound operations, their oversight does not
necessarily ensure that 7( a) portfolios are managed prudently.
Perhaps of greater importance were weaknesses in oversight of
SBLCs, which are licensed, regulated, and supervised by SBA. In
our 1998 review of 5 of SBA's 69 district offices, we found that
SBA had not conducted the regular, periodic reviews of lender
compliance with its 7( a) loan standards or met its own standards
for SBLC oversight. In commenting on this report (see app. IV),
SBA stated that it has since reviewed all preferred lenders, and
that the Farm Credit Administration, through an agreement with
SBA, has completed the on- site portions of the SBLC reviews.
While we have not evaluated these

19 GAO/GGD-98-85. Although the 7( a)

Secondary Markets Help SBA Serve Small Business Borrowers, They
Provide a Means for Concentration of Credit Risk

B-278635 Page 19 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

initiatives, they appear to be the type of actions that could
mitigate credit risk to the agency resulting from lender
concentration.

SBA's final rule, promulgated February 10, 1999, and effective
April 12, 1999, includes provisions that are intended to control
the agency's credit risk in the 7( a) program. As discussed in
further detail in appendix II, the final rule stipulates capital
requirements for lenders and establishes requirements that lenders
retain a subordinated interest in securities they create, based on
each lender's loss rate. The final rule also provides a monitoring
component whereby a decline in a securitizer's performance would
trigger suspension of certain lending privileges.

The pooling of loans in the 7( a) secondary market is an
innovation widely applied in the much larger secondary markets for
single- family 20 residential mortgage loans, where whole mortgage
loans, rather than separate portions of loans, are pooled to
create tradable financial claims in the form of MBS. Compared to
the secondary markets for 7( a) loans, the secondary markets for
residential mortgages operate with greater incentives for lenders
to sell the loans they originate. A comparatively greater
proportion of mortgage lenders has an economic incentive to sell
loans in the secondary market because they rely on secondary
mortgage markets as their most important source of funding. In
addition, depository institutions' needs to manage interest rate
risk associated with mortgage loans, coupled with risk- management
opportunities provided by the secondary markets, provide an
important incentive for those lenders to sell mortgage loans they
originate. These factors, as well as the comparatively larger size
of the primary and secondary markets in residential mortgages,
contribute to larger percentages of residential mortgages being
sold in secondary markets compared to 7( a) loans sold in 7( a)
secondary markets. In the secondary mortgage markets, investors
are better able to estimate cash flows and risks from investments
backed by pools of mortgage loans. Investors are comparatively
less able to reliably estimate cash flows and risks from
investments backed by 7( a) loans because they lack historical
data on the performance of similar loans under varying economic
conditions and because the loan pools are heterogeneous.

Nearly all federally insured single- family mortgages originated
in 1997 were sold on the Ginnie Mae secondary market, compared to
about 45 percent of the guaranteed portions of 7( a) loans on its
respective secondary market. In the secondary market for
conventional single- family

20 Housing units contained in structures with one to four housing
units are considered single- family housing units. Comparison of
the

SBA 7( a) Secondary Markets With the Secondary Markets for
Residential Mortgages

B-278635 Page 20 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

residential mortgages without federal insurance, also known as the
conventional conforming market, about 46 percent of the mortgages
originated in 1997 and eligible for purchase by the enterprises
was sold compared to about 11 percent of unguaranteed portions of
7( a) loans originated that year. Among single- family
conventional residential mortgages originated in 1997 and not
eligible for purchase by the enterprises, about one- third were
sold in this secondary market, called the nonconforming market.
The percentage of conventional mortgages, both conforming and
nonconforming, that were originated and sold in secondary markets
was much greater than that for the unguaranteed portions of 7( a)
loans. In addition, a greater percentage of fixed- rate
conventional mortgage loans was sold in secondary markets than
variablerate loans.

Greater homogeneity of single- family residential mortgage loans
compared to 7( a) loans contributes to a higher percentage of
loans sold in secondary markets. Similarities among residential
mortgage loans, such as being backed by the same types of
collateral, along with standard loan terms, increases the ability
of secondary market investors to evaluate cash flows and loan
collateral values and therefore the various risks associated with
purchasing MBS.

Finally, the bigger sizes of the primary and secondary markets in
residential mortgages relative to the respective markets in 7( a)
loans contribute to the larger percentages of residential
mortgages sold in secondary markets. Large mortgage loan pools
allow more precise risk estimates and lower fees (per dollar
loaned) associated with maintaining a secondary market. Table 1
displays statistics on the shares of residential mortgage loans
and guaranteed portions of 7( a) loans sold in secondary markets
in 1997.

Dollars in billions

Originated Sold Percent sold

Federally insured mortgages $102 $102 100 Conventional conforming
mortgages 560 257 46 Nonconforming conventional mortgages 198 63
32

Table 1: Residential Mortgages and Portions of 7( a) Loans
Originated and Sold in Secondary Markets in 1997

B-278635 Page 21 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Dollars in billions

Originated Sold Percent sold

Total conventional mortgages 758 320 42 Unguaranteed portions of
7( a) loans 2.7 .29 11 Guaranteed portions of 7( a) loans 6.0 2.7
45 Sources: OFHEO and SBA.

Nondepository institutions benefit relatively more from these
secondary markets because they do not have a deposit base with
which to finance the loans they make. Mortgage companies originate
mortgages for resale in the secondary markets as a means to fund
further mortgage originations. These companies retain servicing
rights when they sell mortgages, thereby earning income from
collecting and processing mortgage payments. Mortgage companies
include independent firms without deposit bases as well as
subsidiaries of depository institutions. They originate about
threefourths of federally insured, and about one- half of
conventional, singlefamily mortgage loans. Because they can use
the proceeds of their secondary market loan sales to finance more
mortgage loans, the secondary mortgage markets allow mortgage
companies to compete in the primary market for loan origination
and servicing, even though they do not have a deposit base to
finance the mortgages on their balance sheets. One reason mortgage
companies originate a higher share of federally insured than
conventional mortgages is the presence of an active secondary
market in federally insured, fixed- rate residential mortgages
dating back to the 1930s.

Unlike the mortgage market where nondepository institutions
originate a majority of the loans, the vast majority of 7( a)
loans are originated by depository institutions. However, as with
mortgage loans, the 7( a) secondary markets allow nondepository
institutions to compete in the primary 7( a) market for loan
origination and servicing, even though they do not have a deposit
base to finance 7( a) loans on their balance sheets. 21 While
mortgage companies fund mortgages from origination until time of
sale in the secondary market, they do not permanently fund any
portion of the originated loans on their balance sheets. In
contrast, SBLCs have used debt sources, such as bank lines of
credit, to fund the unguaranteed portion of 7( a) loans on their
balance sheets. At the end of 1997, SBLCs accounted for about 19
percent of outstanding 7( a) loans.

21 Some SBLCs have funded unguaranteed portions of 7( a) loans
without relying on the unguaranteed secondary market for funds.
Some Institutions Rely on

Secondary Markets as a Primary Source of Funds

B-278635 Page 22 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

The presence of interest rate risk in a primary market increases
the attractiveness of the secondary market to loan originators who
may depend on a deposit base as a permanent funding source.
Depository institutions can use their deposit base as a source of
funding with costs that fluctuate frequently. These institutions
use the secondary markets to manage interest rate risks. Long-
term, fixed- rate loans generate interest rate risk for lenders
who depend on a deposit base for funding loans because increases
in short- term funding costs are not accompanied by increases in
interest payments on existing loans. 22 Variable- rate loans, of
which adjustable- rate mortgages are one type, can also generate
interest rate risk for lenders if caps are imposed on the maximum
allowable increases in interest rates.

Prior to the 1990s, virtually all FHA- insured mortgages were
fixed- rate. 23 Currently, over 70 percent of FHA- insured
mortgages are fixed- rate mortgages. In addition, for adjustable-
rate mortgages, FHA limits the degree to which interest rates paid
by the borrower can increase to a maximum of 1 percentage point
annually and 5 percentage points over the life of the mortgage
loan, which acts to limit interest rate risk to the borrower but
shifts this risk to the lender. As a result, FHA- insured
adjustable- rate mortgages also entail interest rate risk for
lenders. Nearly all federally insured residential mortgages were
sold in the Ginnie Mae guaranteed secondary mortgage market in
1997. 24 By comparison, about 45 percent of guaranteed portions of
7( a) loans were sold in the guaranteed secondary market in 1997.

Over the past decade, depository institutions have played a
relatively larger role in the origination of conventional rather
than federally insured mortgages. Adjustable- rate mortgages
currently account for about 20 to 25 percent of all single- family
conventional mortgages. 25 That percentage has been higher for
nonconforming conventional mortgage loans originated. 26

22 Even in the absence of interest rate risk, mortgage bankers
sell residential mortgage loans they originate in the secondary
market. 23 In our analysis of the secondary market for federally
insured residential mortgages, we focused on the major primary
market comprised of FHA- insured residential mortgages. 24 The
active, long- standing secondary market in fixed- rate, federally
insured mortgages dating from the 1930s; the greater presence of
mortgage companies in the primary, federally insured origination
market; and the higher interest rate risk on federally insured
mortgages contribute to this outcome.

25 OFHEO estimates based on monthly survey tabulations compiled by
the Federal Housing Finance Board. 26 This observation is based on
an analysis using mortgage origination data for the years 1989
through 1993. Depository Institutions Use

the Secondary Markets to Manage Interest Rate Risk

B-278635 Page 23 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Interest rate caps vary among conventional mortgages, but most
typically are 2 percentage points annually and 6 percentage points
over the life of the mortgage loan. These more flexible caps allow
for less interest rate risk to the lender on conventional than on
FHA- insured adjustable- rate mortgages. Based on the assumption
that 20 to 25 percent of all singlefamily residential mortgages
are adjustable rate, in the overall single- family residential
mortgage market (i. e., federally insured and conventional),
roughly 30 percent of adjustable- rate, and slightly over 50
percent of fixedrate, outstanding mortgage loans were sold in
secondary markets. 27 The 30- percent figure for adjustable- rate
mortgages generally corresponds to the percentage of the
guaranteed portions of 7( a) loans sold in its secondary market.

In contrast to mortgage loans where fixed- rate loans prevail,
about 90 percent of 7( a) loans originated in 1997 were variable-
rate loans that adjust quarterly without interest rate caps.
Because of this, depository institutions have minimal exposure to
interest rate risk when they use their deposit bases to finance 7(
a) loans and thus have less incentive to sell on the secondary
market than if their risk were higher. 28

MBS investors face prepayment risk that mortgage buyers will pay
off their mortgages before the final payment date. Residential
mortgage borrowers typically prepay their fixed- rate mortgage
loans when mortgage interest rates decline significantly below
that of their existing mortgage. As a result, investors in MBS
backed by cash flows from fixed- rate mortgage loans may not
benefit from higher yields when interest rates in the economy
decrease because many of the mortgages backing the MBS may be paid
off, thereby terminating the cash flows from those mortgages. The
yield for these investors, however, does not increase when
interest rates in the economy rise above those in the mortgages
backing the MBS. SBA 7( a) borrowers typically prepay when they
find better alternatives; from the standpoint of the investor
prepayment also occurs with borrower default. Because most 7( a)
loans have variable interest rates, prepayments based on
economywide interest rate changes are less likely.

27 OFHEO estimates based on statistics presented in Inside
Mortgage Finance (1997 annual) and the assumption that between 20
and 25 percent of single- family residential mortgages outstanding
at yearend 1997 were adjustable rate.

28 Even in the absence of interest rate risk, nondepository
institutions such as SBLCs tend to sell guaranteed portions of 7(
a) loans on the secondary market. We also note that SBA interest
rate restrictions may reduce lender incentives to make fixed- rate
loans because the restrictions preclude lenders from collecting
higher interest rates from borrowers willing to pay higher rates
to avoid interest rate risk. Lenders are restricted to interest
rates that do not exceed the prime interest rate plus 2.25
percentage points for loans with maturities of less than 7 years
and the prime rate plus 2.75 percentage points for loans with
longer maturities. Prepayment Risk Exists in

Residential Mortgage and 7( a) Secondary Markets

B-278635 Page 24 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Residential mortgage borrowers with fixed- rate mortgages tend to
prepay loans when interest rates decline because they can reduce
their monthly mortgage payments by refinancing at the lower rates.
Other prepayment situations occur when a borrower sells a
residence or, in the case of guaranteed or insured mortgages, when
foreclosure action against a borrower generates a prepayment.
However, most mortgage prepayments occur because of declining
interest rates, such as in 1993, when a majority of mortgage
originations were refinancings as interest rates declined. This
form of prepayment is easier to forecast due to the presence of
future interest rate forecasts and historic data on the
relationship between interest rate movements and mortgage
prepayments.

Prepayments for 7( a) loans are tied more to business performance
than to the movement of interest rates in the general economy and,
as a result, are not as predictable as mortgage prepayments. As
with residential mortgage borrowers, 7( a) borrowers have an
incentive to prepay their 7( a) loans when the opportunity to
obtain loans at more favorable terms arises. However, the
determining factors for these prepayment opportunities differ for
7( a) borrowers. As most 7( a) loans have variable interest rates,
these rates decrease in tandem with declining interest rates in
the economy. SBA 7( a) loans serve a wide variety of businesses
and business owners who then experience varying levels of
financial success. Those that experience financial success or
establish good credit can prepay their 7( a) loans by obtaining
conventional loans at more favorable rates from private market
lenders. On the other hand, those that default trigger SBA
guarantee payments to prepay the guaranteed portions of the loans.
These forms of prepayment are more difficult to forecast than
residential mortgage prepayments. This also shortens the period
during which investors who paid premiums for 7( a) pool
certificates will realize the higher yields they anticipated. As a
result, whatever prepayment risk exists for investors in 7( a)
pool certificates and pool securities, it is magnified for
investors who pay premiums 29 on guaranteed pool certificates
because they are less likely to recoup their premiums when
borrowers prepay.

29 Investors are willing to pay prices higher than the par value
of the guaranteed portions backing guaranteed pool certificates
when they expect to realize higher yields over the life of the
loans backing the pool. Prepayments by Residential

Mortgage Borrowers Depend on Overall Interest Rates

Prepayments by 7( a) Borrowers Depend on Business Performance

B-278635 Page 25 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

When government guarantees covering loan payments are absent,
lenders, issuers, and investors face credit risk because losses
occur when borrowers default on their loan payments. Secondary
market participants have developed methods to project expected
cash flows and determine credit risk on a given pool of loans
using lender, borrower, and loan characteristics. Lenders
establish underwriting standards, which include maximum loan- to-
value ratios and loan payment- to- income ratios. Other issuers,
such as Fannie Mae and Freddie Mac, have their own established
underwriting standards. To insure themselves against losses,
issuers often require lenders to provide credit enhancements and
borrowers to purchase mortgage insurance. However, such
requirements could reduce lenders' incentives to sell their loans
on secondary markets.

Lenders limit their own credit risk by establishing underwriting
standards for the loans they make and developing relationships
with borrowers. Because the performance of the individual borrower
is especially important to the cash flows for business loans,
relationships with borrowers, in addition to protections created
through underwriting, are more important in assessing credit risk
for business than residential mortgage loans.

Securities issuers establish practices intended to help ensure
that lenders who sell their loans have incentives to limit credit
risk on those loans. For example, lenders who provide credit
enhancements share the credit risk with MBS issuers and investors.
MBS issuers often reduce their exposure to credit risk by
requiring borrowers to purchase private mortgage insurance from a
mortgage insurance company. These companies, in turn, also
establish underwriting standards.

The enterprises provide corporate guarantees for timely payment of
principal and interest on MBS backed by single- family residential
mortgage loans they purchase. Where the loan amount exceeds 80
percent of the value of the housing unit serving as collateral,
they normally require borrowers to purchase private mortgage
insurance. The enterprises generally do not require lender-
provided credit enhancements on singlefamily mortgage loans they
purchase. They estimate and manage their exposure to credit risk
using techniques developed to estimate the value of housing
collateral, loan- to- value ratios, borrower payment burdens, and
the relationships between these variables and loan losses.
Lenders, Securities Issuers,

and Investors Face Credit Risk in Secondary Markets Without
Government Guarantees

B-278635 Page 26 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Private- label conduits 30 that purchase single- family
residential mortgage loans not eligible for purchase by the
enterprises follow some of the same practices as the enterprises.
Private- label conduits provide guarantees for timely payment of
principal and interest, but unlike the enterprises, they normally
pass on some of the credit risk to MBS investors. Private- label
conduits also rely on private mortgage insurance and use the same
techniques as the enterprises to manage their exposure to credit
risk. The conduits, however, use forms of credit enhancement, such
as subordination, not normally used by the enterprises. 31 As
previously mentioned, credit enhancement is used to maintain
scheduled payments to investors if borrowers go into default or
are late in making payments and to bring securities to investment-
grade ratings, as they act to mitigate the investor's credit risk.
Providing such loss protection comes at a price to the conduit,
because net proceeds the conduit pays the lender will be lowered
by the cost of providing the credit enhancement, thus lowering the
lender's incentive to securitize the loans. In 1997, about one-
third of nonconforming conventional mortgages were sold in the
secondary mortgage market.

In 1997, about 11 percent of unguaranteed portions of 7( a) loans
were sold in the secondary market 32 compared to about 32 percent
of nonconforming loans sold in the secondary mortgage market. One
reason given for the lack of development of unguaranteed 7( a)
secondary market is the relatively high costs to secondary market
investors and rating agencies for monitoring 7( a) lenders and
borrowers to assess credit risks based on available data. These
costs are exacerbated by loan heterogeneity, including the various
forms of businesses financed. For example, the value of the
business funded is largely determined by the performance of the
business operators. In contrast, the value of a housing unit
providing collateral for a residential mortgage loan can be
determined with little regard to borrower characteristics.

30 Private- label conduits are private firms that purchase loans
and repackage them for sale as securities. 31 Other forms of
credit enhancement that have been used include bank letters of
credit that guarantee payment of principal and interest due on an
MBS if the conduit fails to do so and over- collateralization. In
the latter form of credit enhancement, the MBS issuer provides
mortgage loans in excess of the pool of loans securitized to
absorb potential losses resulting from borrower default.

32 Since sales of unguaranteed portions were authorized by SBA in
1992, $1. 2 billion of unguaranteed portions have been sold,
compared to over $63 billion in nonconforming loans sold in the
secondary market in 1997 alone.

B-278635 Page 27 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Due to a number of factors, investors have a greater ability to
estimate risks in secondary markets for residential mortgage loans
compared to 7( a) secondary markets. The most important factor we
have identified is the greater homogeneity of residential mortgage
loans backing each MBS, compared to that of 7( a) loans backing 7(
a) pool certificates and securities. Investors' ability to
estimate risk of securities backed by pools of loans is also
affected by the availability of historical data on loan
performance of similar loans under varying economic conditions and
information provided to investors.

Reliable estimates of prepayment rates and loan losses can be more
easily attained when loan pools are geographically diverse, loans
are relatively homogeneous, and historical data on prepayments of
similar loans under varying economic conditions are available. The
greater homogeneity of residential mortgage loans backing each
MBS, compared to that of 7( a) loans backing 7( a) pool
certificates, facilitates estimating investors' prepayment and
credit risks. The presence of large, geographically diverse loan
pools and large historic databases of residential mortgage loan
performance experience on loans with common characteristics also
facilitates estimating the prepayment risk of MBS investors
relative to 7( a) secondary market investors. The low level of
unguaranteed portions securitized to date reflects the difficulty
of estimating prepayment and credit risks on heterogeneous loans.

Cash flows of residential mortgages with equivalent payment terms
(e. g., 30- year fixed- rate, 15- year fixed- rate, or adjustable-
rate payment terms) back each single- family MBS, and participants
in the secondary market can analyze large historic databases of
prepayment histories of residential mortgages. The Bond Market
Association establishes benchmark prepayment rates based on
historic experience. Securities dealers use historic databases and
financial forecast models to estimate future prepayment rates on
mortgage loans that back each MBS issuance, which they, in turn,
relate to the Bond Market Association benchmarks. Geographic
diversification of a loan pool backing an MBS issuance lessens the
probability that an unexpected adverse change in economic
conditions in any one part of the nation will have a large impact
on the cash flows backing the MBS. Large databases with historic
information on prepayments for loans with specific characteristics
are not available for the 7( a) markets as they are in the
secondary mortgage markets, which means that investors in 7( a)
secondary markets cannot estimate their credit and prepayment
risks as well as MBS investors can. Investors Have Greater

Ability to Estimate Risks in Residential Mortgage Secondary
Markets

Features of Pools and the Availability of Certain Historical Data
Affect Risk Estimates

B-278635 Page 28 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

The heterogeneity (i. e., the wide variety of unique
characteristics) of 7( a) loans lessens the ability of investors
to estimate prepayment risk because the effects of some unique
characteristics cannot be estimated. SBA 7( a) loans differ in
collateral type and the type of business to which each loan is
made. Even within each business category, the performance of small
business loans is heavily affected by business- owner capabilities
that are not captured in historic databases. In addition, when
individual loan pools are relatively small the presence of a few
loans with unique characteristics can have a relatively large
impact on the prepayment experience of the loan pool. The presence
of a large number of lenders making a relatively small number of
loans can also affect prepayment risk estimation due to the
presence of unique characteristics relating to lenders and their
loan practices. As table 2 shows, each 7( a) guaranteed pool
averaged 26 loans in contrast to 42 loans for each Ginnie Mae MBS
issued in 1997.

Ginnie Mae requires that its MBS investors receive an offering
statement that discloses the issuer-- normally the lender-- of the
MBS, the maturity dates, the principal amount of loans in the
pool, and loan characteristics, such as whether they are fixed- or
adjustable- rate. 33 Each month, Ginnie Mae computes a factor
number, based on the remaining principal balances reported monthly
by MBS issuers, for each loan pool. These factors are used to
determine the amount of the original principal that will remain
outstanding after the next payments are made on the pooled loans.
Ginnie Mae requires each approved issuer to apply for commitment
authority to issue a maximum dollar of MBS. Determinations of
commitment authority levels for the largest lenders are based on
examinations of each lender's financial capacity and lending
practices. Ginnie Mae guaranteed MBS are exempt from SEC
registration and reporting requirements. (A discussion of the
securities laws as they apply to the registration of the
securities offer in the secondary markets in residential mortgages
and SBA 7( a) loans appears in app. III.)

While private- label MBS are subject to SEC registration and
reporting requirements, Fannie Mae and Freddie Mac MBS are exempt
from these requirements. However, according to enterprise
officials, information on the offering statements for Fannie Mae
and Freddie Mac MBS parallels that provided by private- label
conduits. In addition to details provided in

33 Ginnie Mae has two guarantee programs for single- family MBS,
Ginnie Mae I and Ginnie Mae II. In Ginnie Mae I, each securities
issuer makes separate monthly payments directly to each securities
holder. In Ginnie Mae II, a central paying and transfer agent
collects payments from all issuers and makes a monthly
consolidated payment to each securities holder for all of its
Ginnie Mae II holdings. The Ginnie Mae II program provides a
mechanism for issuance of MBS backed by multiple issuer loan
pools. As of September 30, 1997, Ginnie Mae I accounted for over
70 percent of Ginnie Mae guaranteed single- family MBS.
Information Disclosed Can Also

Affect Risk Estimation

B-278635 Page 29 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Ginnie Mae offering statements, those provided by the enterprises
and private- label conduits include the geographic distribution of
housing units financed by loans in each pool, detailed description
of loan characteristics, and detailed discussion of risk factors.

SBA 7( a) pool certificates are also exempt from SEC registration
and reporting requirements. SBA requirements for information
provided investors in 7( a) pool certificates are somewhat similar
to Ginnie Mae information requirements for its guaranteed MBS. SBA
requires that 7( a) pool certificate investors be provided
information on interest rate, maturity date, and aggregate
original pool principal amount, as well as the pool certificate's
estimated constant prepayment rate 34 and the loan pools used in
determining the rate. SBA's fiscal and transfer agent provides
monthly factor tables similar to those provided for Ginnie Mae.
SBA officials told us that dealers can provide information on pool
certificates they resell to other investors, but that in many
instances such ongoing information on loan pools, such as which
loans in a pool have been paid off, is not available to investors.

Because unguaranteed 7( a) pool securities are not backed by the
SBA guarantee and are not considered agency securities, they are
subject to SEC registration and reporting requirements. 35
Information provided on the prospectuses for public offerings that
we reviewed included investment risks; the number of loans in a
pool; the states where the loans were originated; and loan
maturities, forms of loan collateral, and interest rates. However,
the small volume in this secondary market reflects the negative
impact of loan heterogeneity on the share of loans sold in this
secondary market.

SBA officials told us that they are currently considering
proposals for expanding information the agency makes available to
investors in 7( a) pool certificates. For example, they told us
that they are considering disclosing information such as the state
where a small business is located and the industry in which it
operates. Officials said that they are willing to consider
providing such information now that the average number of loans
backing each pool has grown from 18 in 1992 to 26 in 1997. In
larger pools, such information is less likely to reveal the
identity of individual borrowers

34 A constant prepayment rate is the return rate at which the
investor can expect to receive payments on the cash flow from the
pool of loans backing the security. 35 Information disclosed in
the private placement issuance of unguaranteed 7( a) securities
can differ from public offerings. We did not analyze 7( a) pool
securities or MBS issuance electing the private placement
exemption.

B-278635 Page 30 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

and expose them to potentially burdensome investor inquiries. The
officials told us that such disclosures could negatively affect
loan marketing for loans in locations and industries that may be
construed as having relatively large prepayment risk. SBA
officials told us that, while they had previously considered
introducing fixed- rate loans with prepayment penalties and
relaxing interest rate ceilings on fixed- rate loans, they
believed that such changes would result in smaller pool sizes that
could negatively affect prepayment risk diversification.

Characteristic Guaranteed 7( a) Market Ginnie Mae MBS Market

Average number of loans per pool issued in 1997 26 42 Number of
lenders servicing loans in secondary market in 1997

1,540 354 Average number of pooled loans per lender in 1997 8 2,
874 Individual lender /issuer limits on maximum level of loan
sales

No volume limits are placed on poolers of 7( a) loans. Every
approved issuer must

apply for commitment authority to issue a specified

maximum dollar amount of MBS. Minimum number of loans in pool 4 8
Minimum aggregate principal amount in a single loan pool $1
million $1 million Maximum percentage of aggregate principal that
can be accounted for by any single loan

25% 20% Maximum range of interest rates The loan with the highest

interest rate can be no more than 2 percentage points above loan
with the lowest

interest rate. Loans in a single lender pool

must all have the same interest rate; interest rates on

loans in a multi- lender pool must be within 1 percentage

point of each other. Sources: SBA and Ginnie Mae.

Over $500 billion in MBS guaranteed by Ginnie Mae is currently
outstanding. Ginnie Mae approved lenders issue MBS backed by cash
flows from federally insured residential mortgages. Ginnie Mae's
fee of 6 basis points covers its guarantees for timely payment of
principal and interest on these securities and pays for business
expenses; default losses not covered by primary mortgage
insurance; and contractual payments to business firms that provide
processing, payment, and transfer services. Lenders that issue
Ginnie Mae guaranteed MBS can retain 44 basis points of
outstanding principal balance for servicing the mortgage loans.

Table 2: Characteristics of the Guaranteed 7( a) and Ginnie Mae
Secondary Markets

Fees Per Dollar of Loan Are Lower in the Residential Mortgage Than
the 7( a) Secondary Markets

B-278635 Page 31 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Therefore, the interest rate spread between the interest rate paid
by the borrower and received by the MBS investor is about 50 basis
points.

More than $1.3 trillion in MBS guaranteed by Fannie Mae and
Freddie Mac was outstanding as of June 30, 1998. Most single-
family residential mortgages purchased by the enterprises are
conventional mortgages without federal insurance. Guarantee fees
charged by the enterprises average about 20 basis points per loan.
With these fees, the enterprises cover default losses; business
expenses; and payments to contractors for processing, payment, and
transfer services. According to a Fannie Mae official, lenders who
sell residential mortgages to the enterprises are allowed to
retain, on average, about 30 basis points of outstanding principal
balance for servicing the mortgage loans. 36 Therefore, the
interest rate spread between the interest rate paid by the
borrower and received by the MBS investor is approximately 50
basis points.

About $10 billion in 7( a) pool certificates is currently
outstanding. SBA 7( a) lenders sell their loans to pool assemblers
who form pools by combining loans from various lenders and then
sell certificates backed by these pools. Colson Services, SBA's
fiscal and transfer agent, monitors and handles the paperwork and
data management system for all 7( a) guaranteed portions sold on
the secondary market and serves as a central registry for all
sales and resales of these portions. Lenders pay Colson 12.5 basis
points of the certificates' value for the firm's secondary market
services on guaranteed portions under its management. This cost,
relative to Ginnie Mae's entire 6 basis point fee suggests that
large volumes of activity generate economies of scale in the
provision of functions such as processing, payment, and transfer
services.

SBA does not limit the amount of servicing fees that lenders can
retain on guaranteed portions of 7( a) loans they sell. Lenders'
servicing fees generally range from 100 to 300 basis points.
According to Colson officials, lenders who collect servicing fees
in the lower portion of this range are more likely to sell their
loans at a premium. As lenders use servicing fees, in part, to
compensate for the credit risk they incur from the unguaranteed
portions of 7( a) loans, these servicing fees are not comparable
to servicing fees retained by residential mortgage lenders.

36 The lower servicing fee for conventional, in comparison to FHA-
insured, mortgages could reflect the impacts of more intensive
servicing requirements or contracting arrangements for FHA-
insured mortgages.

B-278635 Page 32 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

A financial market is more liquid if market participants can buy,
sell, and resell large amounts of holdings without affecting the
prices of traded securities. In 1997, the dollar amount of resold
Ginnie Mae guaranteed MBS was more than twice that of newly issued
Ginnie Mae MBS, while in the 7( a) certificate market resales
accounted for just over a third as many sales as newly issued
certificates. Based on this evidence and discussions with SBA
officials, we have concluded that Ginnie Mae guaranteed MBS and
MBS issued by the enterprises and private- label conduits are more
liquid than 7( a) pool certificates and securities. The
homogeneity of single- family mortgage loans and the availability
of a large historical database of information on them allow MBS
investors to better estimate cash flows and risks than investors
in 7( a) loans. Also, federal insurance and the timely payment
guarantee eliminate credit risk to the investor in Ginnie Mae
guaranteed MBS. While SBA's timely payment guarantee on pool
certificates aids liquidity, the problems inherent in estimating
prepayment risk on 7( a) loans because of their heterogeneity
hinder liquidity. The relative lack of available information on
resold pool certificates, compared to newly issued certificates,
also limits liquidity on resales.

While we lack resale statistics for private- label MBS, enterprise
officials have told us that there is a lower level of liquidity in
the nonconforming secondary mortgage market than in the conforming
market. Credit risk in both the nonconforming secondary market and
that for unguaranteed 7( a) pool securities can hinder liquidity.
However, because of the added difficulty in estimating credit risk
on heterogeneous loans, this factor is likely greater for
investors in unguaranteed 7( a) pool securities. In addition, most
7( a) pool securities have been private placements, which by
definition are less liquid investments.

By linking borrowers and lenders in local markets to national
capital markets, secondary markets benefit lenders, borrowers, and
investors. The share of loans in a primary market that is sold in
a secondary market depends on the benefits that particular
secondary market generates. The benefit to individual lenders of
selling loans in a secondary market depends, in part, on demand
for that lender's loans and the availability and costs of the
lender's alternative funding sources. Other considerations include
whether holding loans on the balance sheet or selling them in the
secondary market brings higher returns on invested capital and/ or
lowers the lender's risks. Secondary markets also allow
nondepository lenders, who cannot provide permanent financing to
hold loans, to compete in primary loan origination markets. MBS
Are More Liquid Than

7( a) Pool Certificates and Securities

Conclusions

B-278635 Page 33 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

In 1997, about $2.7 billion in guaranteed portions and about $290
million in unguaranteed portions of 7( a) loans were sold in the
two respective secondary markets, representing about 45 and 11
percent, respectively, of originations that year. Lenders
participating in these markets can reduce funding costs, and they
can pass along some of their savings in the form of more favorable
loan terms to borrowers. However, both 7( a) secondary markets
lack certain attributes that permit reliable statistical risk
analysis. The most important factors relate to primary market
characteristics of 7( a) loans. With recent growth in the 7( a)
guaranteed market and in the number of loans in each loan pool,
SBA is considering proposals to expand information disclosed to
investors in 7( a) pool certificates.

SBA has recently promulgated a rule, effective April 12, 1999,
regarding sale of unguaranteed portions of 7( a) loans on the
secondary market. SBA is concerned that such secondary market
sales could reduce lender incentives to follow prudent lending
standards and thereby increase risk to SBA. SBA is also concerned
about the concentration of credit risk to the agency that could
result from an active unguaranteed secondary market, which could
increase the share of 7( a) loans accounted for by a small number
of large lenders.

The guaranteed and unguaranteed secondary markets in 7( a) loans
are smaller and less active than residential mortgage loan
secondary markets, and a smaller share of loans from the primary
markets are sold in the 7( a) secondary markets. Variances in the
shares of loans sold in these secondary markets reflect certain
factors in the primary and secondary markets. Notable factors
affecting these secondary market outcomes include the relative (1)
preponderance of fixed interest rates in the residential mortgage
market, (2) homogeneity of loan characteristics among loans
contained in each loan pool in that market, and (3) ability of
residential mortgage market investors to evaluate the risks
associated with each loan pool. These factors affect lenders'
incentives to sell loans to mitigate interest rate risk, aid
poolers in assessing loan characteristics, and assist investors in
estimating their risks. Differences in the 7( a) markets lower the
benefits provided by the 7( a) secondary markets compared to the
secondary mortgage market and therefore the incentives to
participate in these markets.

SBA will continue to face a number of challenging issues in the
administration of the two secondary markets for 7( a) loans. As an
example, uncertainties are present in the future development of
the unguaranteed secondary market for 7( a) pool securities. This
secondary market could (1) continue to be small largely as a
result of loan

B-278635 Page 34 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

heterogeneity, (2) allow nondepository institutions to grow with
an associated possible increase in competition in the primary 7(
a) market, or (3) increase concentration risk to the 7( a)
guarantee program.

SBA's Associate Deputy Administrator for Capital Access provided
written comments on a draft of this report, which are summarized
below and reprinted in appendix IV. SBA also provided technical
comments that were incorporated into the report where appropriate.
Ginnie Mae also provided technical comments that were incorporated
into the report where appropriate.

SBA's comment letter stated that the report fairly represents that
the activity level in the secondary market for either the
guaranteed or unguaranteed portion of Section 7( a) loans is a
function of lender liquidity and/ or lender structure. It also
pointed out that since our 1998 report on SBA oversight was
issued, SBA has performed oversight reviews of all of its
preferred lenders and that the Farm Credit Administration, under
an agreement with SBA, has completed the on- site portions of SBLC
safety and soundness reviews. SBA noted that its headquarters is
in the final editing stages of a lender oversight system to be
used by both headquarters and field office staff for reviewing 7(
a) lenders. SBA also stated that it has established a risk
management committee that uses computerized data to manage the
portfolio.

We have not evaluated these initiatives, but they appear to be the
type of actions that could mitigate credit risk to SBA resulting
from lender concentration.

We are sending copies of this report to Senator Christopher Bond,
Chairman, and Senator John Kerry, Ranking Minority Member, Senate
Committee on Small Business; Representative James Talent,
Chairman, and Representative Nydia Velazquez, Ranking Minority
Member, House Committee on Small Business; Representative Danny
Davis, Ranking Minority Member, Government Programs and Oversight
Subcommittee, House Committee on Small Business; The Honorable
Aida Alvarez, Administrator, Small Business Administration; and
other interested parties. Copies will also be made available to
others upon request. Agency Comments and

Our Evaluation

B-278635 Page 35 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Please call me or Bill Shear, Assistant Director, at (202) 512-
8678 if you or your staff have any questions concerning the
report. Other major contributors to this report are listed in
appendix V.

Sincerely yours, Thomas J. McCool Director, Financial Institutions

and Markets Issues

Page 36 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

Contents 1 Letter 38 The Unguaranteed 7( a) Secondary Market Is
Newer and

Smaller Than the Guaranteed 7( a) Secondary Market 38

7( a) Securities Are Issued in Private Placements or Through
Public Offerings

40 Securities Rating Agencies Help Determine How 7( a)

Securities Are Structured 41

In Approving 7( a) Securities, SBA Seeks to Ensure the Safety and
Soundness of the 7( a) Program

43 Appendix I

The Unguaranteed 7( a) Secondary Market

46 The Guaranteed Secondary Market 46 SBA Has Specific
Requirements for Formation of Loan

Pools Backing 7( a) Certificates 46

Pool Certificates are Based on Loan Pools 46 Appendix II

The Guaranteed 7( a) Secondary Market

50 Appendix III SBA Guaranteed Pool Certificates and Ginnie Mae
MBS Are Exempt From SEC Registration and Reporting Requirements

53 Appendix IV Comments From the Small Business Administration

55 Appendix V Major Contributors to This Report

Contents Page 37 GAO/GGD-99-64 Size of the SBA 7( a) Secondary
Markets

Table 1: Residential Mortgages and Portions of 7( a) Loans
Originated and Sold in Secondary Markets in 1997

20 Table 2: Characteristics of the Guaranteed 7( a) and

Ginnie Mae Secondary Markets 30 Tables

Figure 1: The 7( a) Loan Pooling Process 12 13 Figures

Abbreviations

CPR constant prepayment rate CUSIP Committee on Uniform Securities
Identification Procedures Fannie Mae Federal National Mortgage
Association FHA Fair Housing Act Freddie Mac Federal Home Loan
Mortgage Corporation Ginnie Mae Government National Mortgage
Association HUD Department of Housing and Urban Development MBS
mortgage- backed securities OFHEO Office of Federal Housing
Enterprise Oversight SBA Small Business Administration SBLC Small
Business Lending Corporation SEC Securities and Exchange
Commission SPV special purpose vehicle VA Department of Veterans
Affairs

Appendix I The Unguaranteed 7( a) Secondary Market

Page 38 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

This appendix discusses aspects of the unguaranteed 7( a)
secondary market, including its size and development, and how
securities backed by unguaranteed portions of 7( a) loans are
issued. It also discusses the disclosure requirements that pertain
to issuance of the securities. Finally, it discusses regulatory
and market mechanisms in the 7( a) secondary market that help
ensure the safety and soundness of the SBA 7( a) program.

The secondary market for unguaranteed portions of SBA 7( a) loans
is newer and smaller than that for the guaranteed portions. SBA
first authorized the sale of unguaranteed portions of 7( a) loans
on the secondary market in 1992, 8 years after pooled guaranteed
portions were authorized to be sold. Recognizing that
nondepository institution lenders lack customer deposits to fund
their 7( a) lending, SBA initially allowed only those lenders to
securitize their unguaranteed portions. In 1997, about $290
million in unguaranteed portions of SBA loans were sold on the
secondary market compared to $2.7 billion dollars 1 in guaranteed
portions. As of December 31, 1998, 20 pools of unguaranteed
portions totaling about $1.25 billion had been sold since the
sales were authorized in 1992.

Generally, securitizations of small business loans without federal
guarantees have been limited. According to biannual reports issued
jointly by the Board of Governors of the Federal Reserve System
and SEC, 2 based on bank call reports, the total of small business
loans loans of less than $1 million held by domestically chartered
commercial banks was about $370 billion as of June 30, 1998. The
report also stated that less than $3 billion in nonguaranteed
small business loans had been securitized as rated offerings
through the first half of 1998. This total includes about $1.2
billion in securitized unguaranteed portions of SBA loans.

As discussed elsewhere in these reports, the securitization of
small business loans is slowed by characteristics of those loans
that inhibit analysis by rating agencies and investors. The loans
are not homogeneous, underwriting standards vary across
originators, and information on historical loss rates is typically
limited. To the extent that it is cost effective, one or more
credit enhancements can be included in each securitization
transaction to compensate for these characteristics. Credit
enhancements are payment support features that cover defaults and
losses

1 Nearly $2. 6 billion of this was for pooled guaranteed portions,
with the remainder for individually sold guaranteed portions. 2
Report to the Congress on Markets for Small- Business- and
Commercial- Mortgage- Related Securities, September 1996 and
September 1998, submitted pursuant to section 209 of the Riegle
Community Development and Improvement Act of 1994. The
Unguaranteed 7( a)

Secondary Market Is Newer and Smaller Than the Guaranteed 7( a)
Secondary Market

Appendix I The Unguaranteed 7( a) Secondary Market

Page 39 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

up to a specific amount on loans backing a security, thereby
reducing investor need for costly loan- specific information. In
other words, credit enhancements act to increase the likelihood
that investors will receive interest and principal payments even
in the event that full payment is not received on the underlying
loans. However, the higher the level of credit enhancement needed
to sell the securities, the lower the net proceeds from the sale
of the securities and the weaker the incentive for lenders to
securitize their loans.

Securitizations of unguaranteed portions of 7( a) loans may be
limited, in part, by the relatively small number of lenders with
sufficient loan volume to create pools to back the securities.
According to Moody's Investors Service, pool size typically ranges
from 250 to 2,000 loans. (Although SBA sets no minimum number of
loans for these pools, the more loans there are in a pool, the
less risky the securities backed by that pool tend to be. Less
risk translates to lower credit enhancement requirements and
therefore less cost for enhancement, resulting in more profit for
the issuer.) SBA rules currently allow securitizing only pools of
unguaranteed portions of 7( a) loans originated by a single
lender; however, SBA's final rule, effective April 12, 1999,
provides for case- by- case consideration of multiple- lender
securitizations of unguaranteed portions as well. Also, prior to
April 2, 1997, only nondepository institution lenders had been
authorized to securitize those portions of the loans. Of the nine
issuers to date, six are SBLCs.

Several factors could lead to increased issuance of securities
backed by the unguaranteed portions of SBA loans, as follows:

(1) larger portfolio size of some lenders due to the substantial
growth of the SBA program in recent years;

(2) favorable performance of SBA securitizations to date; (3)
recent inclusion of depository lenders among those authorized to
sell securities backed by unguaranteed portions;

(4) pending participation by loan conduits, which will enable the
creation of multilender pools to support securitizations of
unguaranteed portions, as in the secondary market for guaranteed
portions. SBA will consider multilender securitization on a case-
by- case basis, according to a final rule effective April 12,
1999; and Securitizations in the

Unguaranteed 7( a) Market Could Increase

Appendix I The Unguaranteed 7( a) Secondary Market

Page 40 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

(5) ongoing improvements in understanding and underwriting small
business loans, such as credit scoring, 3 which may help determine
and manage credit risks and improve the design of securitizations
based on small business loans.

A lender's unguaranteed portions of 7( a) loans are securitized
through the pooling and sale of those portions to a bankruptcy-
remote special purpose vehicle (SPV). 4 Securities backed by
unguaranteed portions of 7( a) loan portions are issued and sold
to investors in either a private placement or public offering.
Investors receive an ownership interest in the right to receive
the principal of the pooled unguaranteed portions with interest.
The stream of interest and principal payments is divided,
according to the structure of the securitization, into various
classes, which give securities holders differing priorities to,
and allocable interests in, such payment streams.

These offerings are assigned ratings by securities rating
agencies. The most risk- averse investors look for an investment-
grade rating 5 to be reasonably sure of getting reliable cash
flows. Investors willing to take on more risk can invest in lower-
rated offerings, which offer higher expected returns. According to
SBA officials, investors in SBA unguaranteed portions are
generally institutional investors such as banks, pension funds,
and credit unions that typically are required to restrict their
investments to those of investment grade. All 20 securitizations
of unguaranteed portions as of December 31, 1998, were investment-
grade rated.

Securitizations offered for public sale must be registered with
SEC and meet its requirements for disclosure of information
relating to the securities. The Securities Act of 1933 (the
Securities Act) and the Securities Exchange Act of 1934 (the
Exchange Act) require securities' issuers to disclose information
to help investors assess the risks of a particular, publicly
traded security. The Securities Act specifies

3 Credit scoring is an automated process by which information
about an applicant is used to predict that applicant's likelihood
of repaying a loan. It is predicated on the notion that, with a
relatively small number of variables, the probability of default
for a given applicant can be predicted fairly reliably. [Report to
the Congress on the Availability of Credit to Small Business,
October 1997, by the Board of Governors of the Federal Reserve
System.]

4 Historically, the sale of unguaranteed portions has been limited
to single- lender pools, but SBA is considering a rule that would
allow multilender pools. 5 An investment grade rating is one of
the top four ratings given by any of the four leading securities
rating agencies- Moody's, Standard and Poor's, Duff and Phelps,
and Fitch. 7( a) Securities Are

Issued in Private Placements or Through Public Offerings

Public Offerings of 7( a) Securities Must Meet SEC Requirements
for Disclosure of Information

Appendix I The Unguaranteed 7( a) Secondary Market

Page 41 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

registration and disclosure requirements, and the Exchange Act
requires continuing disclosure after a security is issued. The
required disclosures are made in a prospectus or offering
statement that is distributed in connection with the offer and
sale of a security.

In a private placement, the issuer can avoid the costly
registration and reporting process required of a public offering.
6 Administrative and judicial decisions provide the criteria for
determining whether a transaction does not involve a public
offering. 7 In addition, in order to minimize the uncertainty
about reliance on the private offering exemption, SEC has a safe
harbor rule exempting transactions that meet its requirements. 8
In general, private placements are less liquid than publicly
traded securities.

Of the nine issuers of securities backed by the unguaranteed
portion of 7( a) loans, as of December 30, 1998, one-- The Money
Store-- issued publicly traded, registered securities, while the
other eight have sold their securities through private placements.
The Money Store accounted for 40 percent of the total 7( a)
securities transactions as of December 31, 1998, and about two-
thirds of the $1.25 billion total for all securitizations as of
that date.

Securities rating agencies play an important role in determining
how securities should be structured and priced to appeal to
investors. To understand how securities rating agencies approach
the rating of SBA loan- backed securitizations, we reviewed
reports on this subject published by Moody's Investors Service and
Standard and Poor's. 9 According to the reports, the agencies
estimate the ability of a transaction to pay interest and
principal fully and in a timely manner under varying levels of
stress.

The agencies analyze historical performance data, including SBA
loss performance studies of loans from common origination periods
and portfolio data from specific lenders. If a loss curve cannot
be developed

6 15 U. S. C.  77d( 2). 7 Generally, the following criteria apply:
(1) the offering must be made on a limited basis to selected
persons and not pursuant to a general solicitation of the public;
(2) the securities must be sold only to persons who are either
sophisticated in business matters or able to obtain the type of
assistance that will enable them to make informed investment
decisions; and (3) prior to making the decision to buy, the
purchasers must either be furnished with, or given access to,
information that would be obtained through the registration
process.

8 See regulation D (17 C. F. R.  230.501- 08). 9 Moody's Approach
to Rating SBA Loan- Backed Securitization, Moody's Investors
Service, March 29, 1996, and Securitization of Small Business
Administration 7( a) Program Loans, Standard and Poor's, October
18, 1996. Privately Placed 7( a)

Securities Are Exempt From SEC Requirements for Disclosure of
Information

Measured in Dollars, Public Offerings Accounted for Most Activity

Securities Rating Agencies Help Determine How 7( a) Securities Are
Structured

Appendix I The Unguaranteed 7( a) Secondary Market

Page 42 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

for a specific originator due to lack of sufficient historical
data, the SBA aggregate loss curve may be used to project losses
for recently originated pools. Generally speaking, the more
limited the data, the less precise the loan pool performance
estimates can be, which requires a higher level of credit
enhancements. Such factors as the age of the securitized loans in
the portfolio, referred to as seasoning; the degree of industrial
and geographic diversity of the loans in the pool; and the number
of loans in the pool also play a role in loss performance
analyses. 10

In reviewing the originator's and servicer's operations to gain
insight into the policies and procedures they use to originate,
underwrite, and service the SBA loans, a rating agency might look
at such areas as

 management and financial strength,

 credit origination and approval,

 servicing and collection practices,

 back- up servicing,

 workout and liquidation policies,

 environmental issues, and

 data processing and reporting. The Moody's report states that the
ultimate credit quality of a security depends not only on the
riskiness of the underlying loans but also on the manner in which
the transaction is structured to channel the benefits of payments
from borrowers to investors.

As mentioned earlier, SBA 7( a) securities are usually structured
in classes that provide differing streams of interest and
principal payments, reflecting securities holders' differing
priorities to, and allocable interests in, such payment streams. A
typical two- class structure would have senior and subordinate
classes, with the subordinate class typically providing protection
against principal and interest shortfalls for the senior class
after the exhaustion of funds set aside to provide such
protection. The funds that are set aside to provide the protection
come from excess spread 11

10 According to Moody's, Because cumulative losses increase over
time, a highly seasoned pool will have much lower remaining
expected loss and variability than a similar, but less seasoned
pool. 11 Excess spread is the difference between the interest
received on the SBA loan and the rate paid to the buyer of the
securitized interest, after administrative fees have been
deducted. A spread account is a cash account established and
partially funded at transaction closing and built up through
excess spread over time to a predetermined dollar amount. Once the
spread account is fully funded, any amount deposited in excess of
the required balance may be released to the seller or servicer. In
the event of a draw on the spread account, amounts otherwise
distributable to holders of subordinate securities are
subsequently used to replenish the account. All 7( a) Securities
Have

Used Subordination and Excess Spread As Credit Enhancements

Appendix I The Unguaranteed 7( a) Secondary Market

Page 43 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

from the sale of both the guaranteed and unguaranteed portions. 12
All securitizations of the unguaranteed portions of 7( a) loans
done before June 30, 1998, have used subordination and excess
spread from the sale of both the guaranteed and unguaranteed
portions to enhance the securities. Although credit rating
agencies gave subordinated classes lower investment grade ratings
than the senior classes, subordinated classes offer higher returns
to compensate for the added risks.

In order for securitization to be feasible, the interest received
from the loans in the pool must exceed the sum of interest paid to
security holders and the costs of organizing the securitization.
The excess spread from the guaranteed portions and the spread
generated from the sale of the unguaranteed portions have been
used to enhance the credit for transactions where the unguaranteed
portions are securitized. When the lender receives loan payments,
it remits the portion of the payment on the unguaranteed portion,
along with the excess spread (minus fees) to a collections account
established by a trustee for the benefit of the investors. The
trust uses these funds to make necessary payments, such as
interest and principal on the securities, spread account deposits,
and servicing fees. Should a default occur in the pool, the cash
flows that would have come from the defaulted loan would be paid
from the excess fund account until it is depleted.

Because unguaranteed portions lack the SBA guaranty, SBA
involvement in the unguaranteed 7( a) secondary market is limited
to ensuring that the safety and soundness of the 7( a) program are
protected before it approves a securitization. SBA does not set
minimum pool sizes or dictate the range of loan terms for loans in
a pool of unguaranteed 7( a) loan portions as it does for pools of
guaranteed portions. SBA establishes requirements for lenders who
wish to sell their unguaranteed portions on the secondary market.
In this section, we discuss existing and proposed requirements for
securitization of 7( a) loans, which are intended to help ensure
the safety and soundness of the 7( a) program.

12 This form of credit protection creates a link between the two
7( a) secondary markets. The excess spread from the guaranteed
portions that is used to cover credit losses from the unguaranteed
portions serves to increase the yield spread between interest
rates paid by borrowers on the loans and yield paid to investors
on the unguaranteed pool securities. In Approving 7( a)

Securities, SBA Seeks to Ensure the Safety and Soundness of the 7(
a) Program

Appendix I The Unguaranteed 7( a) Secondary Market

Page 44 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

Before a lender can securitize a pool of unguaranteed portions of
SBA 7( a) loans it originated, it must obtain SBA's written
consent. To obtain this consent, the lender must satisfactorily
show that it is retaining an economic risk in the unguaranteed
portions such as keeping a certain percentage of the unguaranteed
portion or of the securitized pool backed by these portions. This
risk- sharing requirement is intended to provide an economic
incentive for lenders to maintain prudent lending practices. The
lender must also meet other criteria in SBA rules for securitizing
these portions.

To effect a securitization of unguaranteed portions that converts
individual loans into several types of marketable securities, a
lender must sell them to a legal entity, known as a special
purpose vehicle, which issues securities that represent ownership
in these portions. SBA rules require that the lender continue
servicing a loan after the pledge or transfer is made. SBA rules
also require that the lender, or a custodian agreeable to SBA,
hold the loans. According to officials at Colson Services, Inc.,
the fiscal and transfer agent for SBA that collects payments on
guaranteed portions from lenders and distributes the proceeds to
investors in guaranteed pools, its role in the secondary market
for unguaranteed portions is limited to holding the notes for SBA.

As mentioned earlier, SBA initially allowed only its nondepository
lenders to securitize their unguaranteed portions. This reflected
SBA's recognition that nondepositories do not have customer
deposits to fund their 7( a) lending. However, the October 1,
1996, Small Business Program Improvement Act of 1996 directed SBA
to promulgate a final rule that applied uniformly to both
depository and nondepository lenders, setting forth the terms and
conditions and other safeguards to protect the safety and
soundness of the program, or cease permitting the sale of the
unguaranteed portion of 7( a) loans after March 31, 1997. After
proposing a rule in February 1997, SBA promulgated an interim
final rule on April 2, 1997, that extended the program to include
depository lenders and set forth some terms and conditions while
it continued its review of securitization issues. On February 10,
1999, the agency promulgated a final rule that became effective on
April 12, 1999.

The rulemaking process included two proposed rules, two public
hearings, and an interim rule as the agency took the time to
consider views and comments of securitization and accounting
experts, representatives of financial regulatory agencies, and
industry representatives in drafting a final rule. A final rule,
promulgated February 10, 1999, and effective April 12, 1999,
generally requires that a securitizer Existing Requirements to

Ensure the Safety and Soundness of the 7( a) Program

New Requirements to Ensure the Safety and Soundness of the 7( a)
Program

Appendix I The Unguaranteed 7( a) Secondary Market

Page 45 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

 have sufficient capital to meet the definition of well-
capitalized used by bank regulators (depository institution), or
maintain a minimum applicable capital equal to at least 10 percent
of its assets, excluding the guaranteed portion of its 7( a) loans
and including any remaining balance in its portfolio or in any
securitization pool (nondepository institution);

 retain for 6 years a subordinated interest in the securities, the
amount of which is the greater of two times the securitizer's loss
rate on its 7( a) loans disbursed for the preceding 10- year
period or 2 percent of the principal balance outstanding at the
time of the securitization of the unguaranteed portions of the
loans in the securitization; and

 be placed on probation for one quarter, and then suspended for at
least 3 months from preferred lender status if the securitizer's
default rate crosses certain thresholds and fails to improve to
SBA's standards. SBA also will not approve additional
securitization requests from that securitizer during the
suspension period.

Appendix II The Guaranteed 7( a) Secondary Market

Page 46 GAO/GGD-99-64 Size of the SBA 7( a) Secondary Markets

This appendix discusses aspects of the guaranteed 7( a) secondary
market, including its size and development and how certificates
backed by guaranteed portions of 7( a) loans are issued. It also
discusses the disclosure requirements that pertain to issuance of
the certificates.

The guaranteed secondary market was created in 1972, when the
first guaranteed portions of individual loans were sold. In 1984,
Congress authorized issuance of pool certificates backed by pools
of the guaranteed portions. Lenders sell their loans to pool
assemblers who form pools by combining the loans of several 7( a)
lenders. Overall, about 88 percent of all loans sold in the
secondary market in 1997 were pooled loans.

SBA prescribes certain characteristics that every pool of 7( a)
guaranteed portions must meet. Each pool must have at least four
loans with a minimum aggregate principal balance of at least $1
million. No single loan can account for more than 25 percent of
the pool. Although all loans in a pool need not have the same
interest rate, they must be either all fixed or all variable rate
loans. If the pool has variable rate loans, all loans must have
the same rate adjustment dates. The pool's interest rate is based
on the loan with the lowest net interest rate, 1 and the range of
these rates cannot be greater than 2 percent. The maturity date
designation for the entire pool is based on the loan with the
longest remaining term to maturity. The remaining term to maturity
for the shortest loan in the pool must be at least 70 percent of
that for the longest. New loans cannot be added to a pool to
replace others that prepay or default. In calendar year 1997, 427
variable rate pools and 5 fixed rate pools were formed, averaging
25 and 9 loans per pool, respectively.

Pool certificates are issued on each pool in denominations of at
least $25,000. Each pool certificate has a unique number, called a
Committee on Uniform Securities Identification Procedures (CUSIP)
number, for identification purposes. 2 They are backed by the full
faith and credit of the U. S. government and have a timely payment
guarantee from SBA. SBA does not charge for its timely payment
guarantee, 3 which ensures that investors will be paid on
scheduled dates regardless of whether payments from borrowers were
on time. This timely payment guarantee applies only to pooled
guaranteed portions of 7( a) loans, and not to individually

1 Net interest rate is the rate of interest, net of fees, on an
individual guaranteed portion. 2 The CUSIP numbering system is
used by the securities industry as a standard shorthand means of
identifying securities. The CUSIP division of Standard & Poor's
assigns these numbers. 3 SBA charges lenders a guarantee fee for
each 7( a) loan they originate, ranging from 2 percent to 3.875
percent of the amount of each loan. The Guaranteed

Secondary Market SBA Has Specific Requirements for Formation of
Loan Pools Backing 7( a) Certificates

Pool Certificates are Based on Loan Pools

*** End of document. ***