Small Business Administration: Secondary Market for Guaranteed Portions
of 7(a) Loans (Testimony, 09/23/1998, GAO/T-GGD-98-184).
Under its 7(a) loan program, the Small Business Administration
guarantees to repay a participating lender a prespecified percentage of
the amount of a 7(a) loan in the event a borrower defaults. Guaranteed
and unguaranteed portions of 7(a) loans are sold in separate secondary
markets. This testimony discusses (1) the benefits generally provided by
secondary loan markets, (2) the characteristics of the secondary market
for federal government guaranteed mortgage loans, and (3) the
characteristics of the guaranteed 7(a) secondary market in relation to
those of the secondary market for Ginnie Mae mortgage-backed securities.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: T-GGD-98-184
TITLE: Small Business Administration: Secondary Market for
Guaranteed Portions of 7(a) Loans
DATE: 09/23/1998
SUBJECT: Small business loans
Mortgage-backed securities
Government guaranteed loans
Loan repayments
Comparative analysis
Mortgage loans
IDENTIFIER: SBA 7(a) Loan Program
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GAO/T-GGD-98-184
Cover
================================================================ COVER
Before the Subcommittee on Government Programs
and Oversight, Small Business Committee
House of Representatives
For Release on Delivery
Expected at 2:00 p.m. EDT
on Wednesday
September 23, 1998
SMALL BUSINESS ADMINISTRATION -
SECONDARY MARKET FOR GUARANTEED
PORTIONS OF 7(A) LOANS
Statement of Thomas J. McCool
Director, Finanical Institutions and Markets Issues
General Government Division
GAO/T-GGD-98-184
GAO/GGD-98-184T
(233583)
Abbreviations
=============================================================== ABBREV
SMALL BUSINESS ADMINISTRATION:
SECONDARY MARKET FOR GUARANTEED
PORTIONS OF 7(A) LOANS
==================================================== Chapter STATEMENT
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to discuss preliminary results of our
ongoing review of the secondary market in Small Business
Administration (SBA) 7(a) loans. Under the program, SBA guarantees
to repay a participating lender a prespecified percent of the amount
of the 7(a) loan in the event of borrower default. Guaranteed and
unguaranteed portions of 7(a) loans are sold in separate secondary
markets. Mr. Chairman, you requested that we review both the
guaranteed and unguaranteed secondary markets in 7(a) loans. For the
purposes of today's hearing, I will limit my focus to the 7(a)
secondary market for the guaranteed portion. My statement has three
objectives. The first is to discuss the benefits generally provided
by secondary loan markets. The second is to describe characteristics
of the secondary market for federal government guaranteed mortgage
loans. In particular, in our review we are focusing on the market
for mortgage-backed securities (MBS) guaranteed by the Government
National Mortgage Association (Ginnie Mae). The third objective is
to describe the characteristics of the guaranteed 7(a) secondary
market in relation to those of the Ginnie Mae MBS secondary market.
In conducting our ongoing analysis on both the guaranteed and
unguaranteed portions of 7(a) loans, we are paying particular
attention to identifying actions that indicate the potential to
improve the efficiency of the SBA secondary market in achieving the
objectives established for it.
Secondary loan markets link borrowers and lenders in local markets to
national capital markets, thus reducing dependence on local funds
availability. The secondary market in residential mortgages is
recognized for creating this link. This secondary market has reduced
regional imbalances in the availability of loanable funds. Other
benefits, which include tapping additional sources of funds, have
also helped to lower interest rates paid by borrowers. In addition,
this secondary market allows interest rate risk inherent in holding
fixed-rate loans to become diversified among investors that might be
better able to hedge against such risks than loan originators. Our
preliminary results indicate that the guaranteed 7(a) secondary
market has also linked borrowers and lenders in local markets to
national capital markets, and thus generated some of the benefits
generally created by other secondary markets. However, the
guaranteed 7(a) secondary market has characteristics that limit its
size in relation to the primary 7(a) market. In particular, most
7(a) loans are variable-rate loans with almost no interest rate risk,
which reduces incentives for some lenders to use the secondary
market. In addition, 7(a) secondary market investors, relative to
MBS investors, have less information to accurately estimate their
exposure to risks associated with borrowers paying off their loans
before they are due (prepayment risks), which may limit whether or
how much they are willing to participate.
To meet the objectives of my statement, we reviewed SBA's standard
operating procedures for its 7(a) program, rules and regulations for
the guaranteed 7(a) secondary market, and other SBA documents
addressing the role of this market. We reviewed studies on the
secondary markets in 7(a) guaranteed loans and residential mortgage
loans conducted by numerous federal agencies and other parties. We
obtained and analyzed data from SBA and the Department of Housing and
Urban Development (HUD). We also interviewed representatives from
SBA, HUD, Colson Services (the program's fiscal and transfer agent),
financial industry regulators, industry associations, and various
7(a) lenders and poolers.
BACKGROUND
-------------------------------------------------- Chapter STATEMENT:1
The 7(a) loan program, SBA's largest lending program, is intended to
serve small business borrowers who cannot otherwise obtain financing
under suitable terms and conditions from the private sector. Under
the program, SBA guarantees to repay a participating lender a
prespecified percentage of the 7(a) loan amount (generally between 75
and 80 percent) in the event of borrower default. To obtain a 7(a)
loan guarantee, a lender must document that the prospective borrower
was unable to obtain financing under reasonable terms and conditions
through normal business channels. Borrowers participating in the
program represent a broad range of small businesses, including
restaurants, consumer services, professional services, and retail
outlets.
The dollar volume of 7(a) loans that can be guaranteed under SBA's
authority is predetermined each fiscal year by congressional
appropriations that subsidize the program. During fiscal year 1997,
7(a) loan approvals totaled nearly $9.5 billion--the highest level of
loan approvals in the program's history and an increase of over 20
percent from the previous fiscal year. As of December 31, 1997,
there was $21.5 billion in total 7(a) loans outstanding.
About 8,000 lenders are approved to participate in SBA's 7(a)
program. They range from institutions that make a few 7(a) loans
annually to more active institutions that originate hundreds
annually. Most of the lenders are insured depository institutions
such as banks and thrifts. Among nondepository lenders active in the
7(a) program are 14 Small Business Lending Companies (SBLC) that
accounted for about 19 percent of 7(a) loans outstanding at the end
of 1997.
SECONDARY LOAN MARKETS GENERATE
BENEFITS
-------------------------------------------------- Chapter STATEMENT:2
A secondary loan market is a resale market for loans originated in
the primary market. It allows a lender to sell a loan it originates
rather than holding the loan on its balance sheet. To hold a loan on
its balance sheet, the lender would be required to obtain funding for
the time period over which the loan was outstanding. For the types
of loans I am discussing, when a lender sells a loan, it continues to
service the loan by collecting borrower principal and interest
payments and taking possible corrective actions if the borrower does
not make required payments. A number of benefits are associated with
secondary markets. They provide lenders a funding alternative to
deposits, lines of credit, and other debt sources. Secondary loan
markets generally link borrowers and lenders in local markets to
national capital markets, which can provide liquidity for lenders and
thereby reduce regional imbalances in loanable funds and possibly
increase the overall availability of credit to the primary market and
lower interest rates for borrowers.
The share of loans in a primary market that are sold in a secondary
market depends on the benefits generated by the secondary market.
For example, secondary markets allow interest rate risk to be
diversified among investors with access to funding sources that help
them manage such risks. Interest rate risk is the possibility of
financial loss due to changes in market interest rates. This risk is
greatest for holders of assets such as fixed-rate loans. For
example, a financial institution holding a 30-year fixed rate
mortgage on its balance sheet that it funds with short-term
liabilities can experience losses if interest rates rise. In this
case, interest earnings from the mortgage do not increase while
interest costs do. Interest rate risk is also present for variable
rate loans with caps that limit how much interest rates paid by the
borrower can increase. Adjustable-rate residential mortgages are an
important example of such a variable-rate loan product. Depository
institutions that rely on short-term deposits for funding have
incentives to avoid holding fixed-rate assets on their balance
sheets. In this case, secondary markets provide a funding source
that is less likely to be disrupted in a changing interest rate
environment.
Other loan risks, such as credit risk and prepayment risk, can limit
benefits and subsequently the share of loans sold in a secondary
market. Credit risk is the possibility of financial loss resulting
from borrower defaults. When secondary market investors are exposed
to credit risk, secondary market sales can be impeded if investors
lack information on lenders, borrowers, and loan characteristics to
estimate their exposure to credit risks. Investors who purchase
federally guaranteed loans and securities are not subject to credit
risk because the federal guarantees ensure that investors will be
paid on defaulted loans. However, lenders and investors are subject
to credit risk on unguaranteed loans or portions of loans.
Prepayment risk is the risk that borrowers will pay off their loans
before maturity. For example, prepayments can lower returns to
investors in fixed-rate loans if borrowers prepay the loans when
interest rates decline. Likewise, for fixed- or variable-rate loans,
prepayments can lower returns to investors who pay a premium for a
pool of loans with relatively high interest rates. Federal
guarantees do not mitigate this risk. Thus, secondary market sales
can be impeded if investors lack information on lenders, borrowers,
and loan characteristics to estimate their exposure to prepayment
risks. Analysts are able, by using various statistical techniques,
to estimate prepayment risks for large loan pools for which
information is available on the pool's loan characteristics and
historic prepayment rates on statistical samples of similar loans.
In contrast, such estimates are less reliable for securities backed
by loan pools composed of a relatively small number of loans. The
size of the pool is important because loans with cash flows that
represent statistical outliers are less likely to cause the cash flow
from a large pool to differ from those of other representative
statistical samples of similar loans.
THE GINNIE MAE GUARANTEED MBS
MARKET IS LARGE
-------------------------------------------------- Chapter STATEMENT:3
Ginnie Mae is a government corporation that is part of the Department
of Housing and Urban Development. Ginnie Mae participating lenders
originate mortgages insured by the Federal Housing Administration
(FHA) and the Department of Veterans Affairs (VA) for resale in the
secondary market. These lenders issue mortgage-backed securities
backed by cash flows from these mortgages. For a fee of 6 basis
points\1 , Ginnie Mae guarantees timely payment of principal and
interest on these securities. Currently, over $500 billion in MBS
backed by Ginnie Mae is outstanding. Most mortgages backing Ginnie
Mae MBS are FHA insured mortgages.
Most Ginnie Mae lenders are mortgage bankers, a group which includes
independent firms without deposit bases as well as subsidiaries of
depository institutions. This secondary market allows mortgage
bankers to compete in the primary market for loan originations even
though they do not have a deposit base to finance the mortgages on
their balance sheets. Due to competitive forces in the primary
market and as a result of increased access to additional sources of
funds for lenders, this secondary market has contributed to lower
interest rates paid by borrowers on federally insured mortgages.
Over 90 percent of single-family FHA mortgages have been sold in the
Ginnie Mae MBS secondary market.
Over 70 percent of FHA insured mortgages are fixed-rate mortgages.
These mortgages have greater interest rate risk than adjustable-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. Therefore, Ginnie Mae guaranteed
MBS backed by FHA-insured adjustable-rate mortgages also entail
interest rate risk for investors. As I discussed earlier, the
presence of interest rate risk in a primary market increases the
attractiveness of the secondary market to loan originators.
An investor in a Ginnie Mae MBS is to receive an offering statement
that discloses the issuer of the MBS, which is normally the lender.
Other information to be disclosed includes the value of loans in the
pool and characteristics of the loans, such as whether they are
30-year fixed-rate or adjustable rate. The minimum pool size is
eight loans, but most pools are much larger. For a fixed-rate MBS
pool, interest rates paid by borrowers in the pool must be within one
percentage point of each other. For MBS backed by adjustable-rate
mortgage pools, the index used to adjust the interest rate paid by
the borrower must be specified. Therefore, in estimating prepayment
risk, the investor is helped by being able to analyze a relatively
large and homogeneous loan pool issued by a particular lender.
Investors in Ginnie Mae MBS include mutual funds, pension funds,
insurance companies, and individuals.
--------------------
\1 A basis point is one one-hundredth of a percentage point.
CHARACTERISTICS OF THE
GUARANTEED 7(A) SECONDARY
MARKET DIFFER FROM THOSE OF THE
GINNIE MAE MBS MARKET
-------------------------------------------------- Chapter STATEMENT:4
In the guaranteed 7(a) secondary market, investors purchase
certificates backed by cash flows from pools of the guaranteed
portions of 7(a) loans. The secondary market for 7(a) pool
certificates started in 1984. This market provides lenders a
potential funding source to originate more small business loans. As
I stated earlier, participating lenders include depository and
nondepository financial institutions. Nondepository institutions
benefit relatively more from this secondary market, because they do
not have a deposit base to help them finance 7(a) loans on their
balance sheets. Particularly active among nondepository lenders are
12 SBLCs that accounted for about 19 percent of 7(a) loans
outstanding at the end of 1997.
In this market, SBA 7(a) lenders sell their loans to pool assemblers
who form pools by combining the loans of a number of lenders and then
sell certificates backed by these pools. Colson Services, SBA's
fiscal and transfer agent (FTA), monitors and handles the paperwork
and data management system for all 7(a) guaranteed portions sold on
the secondary market. Colson also serves as a central registry for
all sales and resales of these portions. The firm receives payment
from lenders for its secondary market services equal to 12 1/2 basis
points of the value of certificates for guaranteed portions under
Colson's management. In 1997, SBA 7(a) secondary market sales of
pooled guaranteed portions was approximately $2.6 billion.
In contrast to Ginnie Mae guaranteed MBS that are backed by cash
flows from whole loans, 7(a) loans are divided into separate
guaranteed and unguaranteed portions for secondary market sales. SBA
reported that in 1997 over 12,000 7(a) guaranteed portions were sold
on the secondary market, about 40 percent of all 7(a) loans approved
that year. In recent years, anywhere from a third to almost half of
the guaranteed portions of loans originated have been sold on the
secondary market. This is in contrast to Ginnie Mae guaranteed MBS,
which represent over 90 percent of outstanding federally insured
residential mortgage loans.
The guaranteed 7(a) secondary market is smaller and less active, and
provides lenders with fewer incentives to sell loans than the
federally insured residential mortgage market. At the end of 1997,
about $10 billion in guaranteed portions of 7(a) loans were
outstanding, while Ginnie Mae guaranteed MBS had over $500 billion
outstanding. The 7(a) market does not benefit from the incentive for
lenders to sell on the secondary market to mitigate interest rate
risk, because the 7(a) program consists mainly of variable-rate loans
without interest rate caps. Almost 90 percent of 7(a) loans made in
1997 were variable- rate loans without interest rate caps. Because
interest rates are adjusted at least quarterly to reflect market
rates, these loans entail almost no interest rate risk. In addition,
SBA 7(a) loans can consist of loans backed by a variety of items,
such as real estate, production inventory, or equipment, and 7(a)
loans finance a broad range of businesses. Residential mortgages are
all backed by residential property.
Because of the heterogeneous nature of 7(a) loans, analysts are less
able to accurately estimate prepayment risks. Some participants in
the secondary market for 7(a) guaranteed portions expressed concern
that information useful to investors in analyzing prepayment risk is
not available when pool certificates are resold, limiting investors'
ability to resell in this market. SBA is concerned that providing
such information to investors could reduce benefits to some 7(a)
borrowers by potentially allowing investors to identify individual
borrowers and groups of borrowers. According to SBA, all investors
in 7(a) guaranteed pool certificates are institutional investors,
such as pension funds, insurance companies, and mutual funds.
In summary, secondary market volume for both the guaranteed portions
of 7(a) loans and federally insured residential mortgage loans is a
market outcome that depends on the relative benefits provided by the
respective secondary markets compared to other methods of finance.
For the most part, SBA has few if any means to change factors that,
through market forces, limit the relative size of the secondary
market. For example, heterogeneity in loan characteristics, which
results from the 7(a) program's intention to serve a broad range of
small businesses, limits the ability of investors to estimate
prepayment risk.
As we continue our work, we will consider SBA actions that indicate
the potential to improve the efficiency of the SBA 7(a) secondary
market in achieving the objectives established for it.
------------------------------------------------ Chapter STATEMENT:4.1
Mr. Chairman, this concludes my prepared statement. I will be happy
to respond to any questions you or other Members of the Subcommittee
may have.
*** End of document ***