oversight

Small Business Administration: Size of the SBA 7(a) Secondary Markets is Driven by Benefits Provided

Published by the Government Accountability Office on 1999-05-26.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to the Subcommittee on
                Government Programs and Oversight,
                Committee on Small Business, House of
                Representatives

May 1999
                Small Business
                Administration
                Size of the SBA 7(a)
                Secondary Markets is
                Driven by Benefits
                Provided




GAO/GGD-99-64
GAO                United States
                   General Accounting Office
                   Washington, D.C. 20548

                   General Government Division



                   B-278635

                   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
Results in Brief   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,


                   Page 1                       GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
B-278635




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
                  1
market liquidity, 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
                                                                           2
developed a sufficient deposit base as a funding source for their loans.
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.
                                                                                       3
In the guaranteed 7(a) market, investors face prepayment risk, and in the
unguaranteed 7(a) secondary market, investors and lenders share
                            4
prepayment and credit risk. 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
                                            5
of one such lender, could be costly to SBA.


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




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




             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
Background   (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.




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




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
                                                    6
when collections from borrowers are not timely.

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
                                            7
statutes; insurance companies; and SBLCs 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.




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




                8
  general. 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
              9
  basis points 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
                          10
  more interest rate risk 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 FHA-
  insured 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
                    11
  secondary market 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




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




              • 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
Scope and       procedures for the 7(a) program and other SBA documents addressing the
Methodology                                                      12
                role of the secondary markets for 7(a) loans. 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.




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




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 SEC-
registered, 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.




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




                             Secondary loan markets, which are resale markets for loans originated in
Secondary Loan               primary markets, link borrowers and lenders in local markets to national
Markets Generate             capital markets, lower costs for funds, and help lenders manage risks.
Benefits and Concerns        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.

Lenders, Borrowers, and      Secondary loan markets can generate a number of benefits for lenders and
                             borrowers. The secondary loan markets provide an alternative funding
Investors Can Benefit From   source in addition to deposits and other funding sources, such as lines of
Secondary Loan Markets       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
                                                       13
                             servicing the sold loans, 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.




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




Credit, Prepayment, and        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
Interest Rate Risks Are        variety of factors affect the levels of these risks in secondary loan market
Primary Risks in Secondary     transactions as well as the parties that incur them, as illustrated by the
Loan Markets                   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
                                               14
                               enhancements 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.




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




                            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.

Secondary Loan Market       As discussed earlier, secondary loan markets give lenders a funding
                            alternative to deposits and other funding sources, such as lines of credit
Benefits to Individual      and the proceeds from debt issuances. The benefit to an individual lender
Lenders Depend on Several   of selling loans in a secondary market depends in part on the comparative
Factors                     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
The Secondary               capital markets, the 7(a) secondary markets--particularly the market for
Markets in SBA 7(a)         guaranteed portions--benefit lenders, borrowers, and investors. The 7(a)
Loans Generate              secondary markets can help borrowers and lenders by reducing regional
                            imbalances and cyclical swings in credit availability and pricing. In 1997,
Benefits and Risks          the guaranteed 7(a) secondary market served as a funding source for many




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




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.




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




Figure 1: The 7(a) Loan Pooling Process




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




Source: SBA.

Investors, poolers, lenders, and SBA face various risks from the 7(a)
                      15
secondary markets. 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.




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




                                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
                                            16
                                1998 report 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.

The 7(a) Secondary Markets      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
Generate Benefits for Many      the guaranteed secondary market and collectively generated $2.7 billion in
Depository and                  sales. About 50 of those lenders used the guaranteed 7(a) market
Nondepository Institutions      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.

Only Nondepository Lenders      In 1992 , SBA authorized the creation of the unguaranteed secondary
Were Authorized to Sell         market as a funding source for nondepository institutions. Since that time,
Unguaranteed Portions of 7(a)   these lenders have been able to sell pools of unguaranteed portions of
Loans in the Secondary Market   their 7(a) loans in the secondary market. In 1996, Congress mandated that
From 1992 Through 1996          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.




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




                             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
                                                                   17
                             be disclosed to prospective buyers. 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.

Borrowers Benefit From the   Although constrained by annual congressional appropriations for the 7(a)
                             loan program, the 7(a) secondary markets can benefit borrowers of
7(a) Secondary Markets       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.




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




Investors Benefit From the   Secondary markets for investments backed by SBA 7(a) loan pools attract
                             a wide range of institutional investors, including pension funds, mutual
7(a) Secondary Markets       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 Purchasing         Investors in guaranteed portions do not face credit risk because the SBA
                             guarantee transfers that risk from the investor to SBA. Investors who
Unguaranteed Portions of     purchase 7(a) pool securities backed by unguaranteed portions face both
7(a) Loans Face Credit and   credit and prepayment risks. They typically share the credit risk with the
Prepayment Risks             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
                                                                          18
                             of credit enhancement uses excess spread, 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.




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




                               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 loan-
                               backed securitizations appears in appendix I.

Investors in 7(a) Pool         To compensate for prepayment risk, investors demand higher yields on
Certificates Face Prepayment   7(a) pool certificates than on Treasury securities with comparable
Risk                           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.




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




Although the 7(a)            The 7(a) secondary markets could also be instrumental in contributing to a
                             concentration of credit risk for SBA. Because SBA generally guarantees 75
Secondary Markets Help       to 80 percent of each 7(a) loan, the failure of one or more large lenders to
SBA Serve Small Business     follow prudent lending practices necessary for making creditworthy loans
Borrowers, They Provide a    can expose SBA to credit risk once those loans go into default. As a large
Means for Concentration of   potential funding source for lenders, the 7(a) secondary markets can
                             enable lenders active in the secondary markets to increase loan volume,
Credit Risk                  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.
                                                   19
                             Our 1998 report 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.




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




                        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
Comparison of the                                                                       20
                        applied in the much larger secondary markets for single-family residential
SBA 7(a) Secondary      mortgage loans, where whole mortgage loans, rather than separate
Markets With the        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
Secondary Markets for   markets for residential mortgages operate with greater incentives for
Residential Mortgages   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.




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




                                        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 variable-
                                        rate 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.



Table 1: Residential Mortgages and
                                        Dollars in billions
Portions of 7(a) Loans Originated and
Sold in Secondary Markets in 1997                                  Originated                Sold         Percent sold
                                        Federally insured
                                        mortgages                        $102                $102                  100
                                        Conventional
                                        conforming
                                        mortgages                         560                 257                    46
                                        Nonconforming
                                        conventional
                                        mortgages                         198                   63                   32




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




                            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.



Some Institutions Rely on   Nondepository institutions benefit relatively more from these secondary
                            markets because they do not have a deposit base with which to finance the
Secondary Markets as a      loans they make. Mortgage companies originate mortgages for resale in
Primary Source of Funds     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 three-
                            fourths of federally insured, and about one-half of conventional, single-
                            family 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
                                                                                                      21
                            do not have a deposit base to finance 7(a) loans on their balance sheets.
                            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.




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




Depository Institutions Use   The presence of interest rate risk in a primary market increases the
                              attractiveness of the secondary market to loan originators who may
the Secondary Markets to      depend on a deposit base as a permanent funding source. Depository
Manage Interest Rate Risk     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
                                                                                22
                              increases in interest payments on existing loans. 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.
                                                                                                                                    23
                              Prior to the 1990s, virtually all FHA-insured mortgages were fixed-rate.
                              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
                                                                                 24
                              guaranteed secondary mortgage market in 1997. 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
                                                                                    25
                              percent of all single-family conventional mortgages. That percentage has
                                                                                                         26
                              been higher for nonconforming conventional mortgage loans originated.

                              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.




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




                            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 single-
                            family 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 fixed-
                                                                                                27
                            rate, outstanding mortgage loans were sold in secondary markets. 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
                                                                                28
                            the secondary market than if their risk were higher.

Prepayment Risk Exists in   MBS investors face prepayment risk that mortgage buyers will pay off their
                            mortgages before the final payment date. Residential mortgage borrowers
Residential Mortgage and    typically prepay their fixed-rate mortgage loans when mortgage interest
7(a) Secondary Markets      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 year-
                            end 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.




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




Prepayments by Residential      Residential mortgage borrowers with fixed-rate mortgages tend to prepay
Mortgage Borrowers Depend on    loans when interest rates decline because they can reduce their monthly
Overall Interest Rates          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 by 7(a) Borrowers   Prepayments for 7(a) loans are tied more to business performance than to
Depend on Business              the movement of interest rates in the general economy and, as a result, are
Performance                     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
                                                              29
                                investors who pay premiums 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.




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




Lenders, Securities Issuers,   When government guarantees covering loan payments are absent, lenders,
                               issuers, and investors face credit risk because losses occur when
and Investors Face Credit      borrowers default on their loan payments. Secondary market participants
Risk in Secondary Markets      have developed methods to project expected cash flows and determine
Without Government             credit risk on a given pool of loans using lender, borrower, and loan
Guarantees                     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 single-
                               family 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.




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




                                 30
Private-label conduits 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
                                                       31
subordination, not normally used by the enterprises. 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
                          32
in the secondary market 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.




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




Investors Have Greater               Due to a number of factors, investors have a greater ability to estimate
                                     risks in secondary markets for residential mortgage loans compared to
Ability to Estimate Risks in         7(a) secondary markets. The most important factor we have identified is
Residential Mortgage                 the greater homogeneity of residential mortgage loans backing each MBS,
Secondary Markets                    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.

Features of Pools and the            Reliable estimates of prepayment rates and loan losses can be more easily
Availability of Certain Historical   attained when loan pools are geographically diverse, loans are relatively
Data Affect Risk Estimates           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.




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




                                 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.

Information Disclosed Can Also   Ginnie Mae requires that its MBS investors receive an offering statement
Affect Risk Estimation           that discloses the issuer--normally the lender--of the MBS, the maturity
                                 dates, the principal amount of loans in the pool, and loan characteristics,
                                                                                      33
                                 such as whether they are fixed- or adjustable-rate. 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.




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




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
                                                        34
pool certificate’s estimated constant prepayment rate 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
                                               35
SEC registration and reporting requirements. 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.




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




                                  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.


Table 2: Characteristics of the
Guaranteed 7(a) and Ginnie Mae    Characteristic                  Guaranteed 7(a) Market           Ginnie Mae MBS Market
Secondary Markets                 Average number of loans per                                  26                               42
                                  pool issued in 1997
                                  Number of lenders servicing                               1,540                             354
                                  loans in secondary market in
                                  1997
                                  Average number of pooled                                       8                          2,874
                                  loans per lender in 1997
                                  Individual lender /issuer limits No volume limits are placed Every approved issuer must
                                  on maximum level of loan              on poolers of 7(a) loans.          apply for commitment
                                  sales                                                             authority to issue a specified
                                                                                                      maximum dollar amount of
                                                                                                                            MBS.
                                  Minimum number of loans in                                     4                               8
                                  pool
                                  Minimum aggregate principal                          $1 million                       $1 million
                                  amount in a single loan pool
                                  Maximum percentage of                                      25%                             20%
                                  aggregate principal that can
                                  be accounted for by any
                                  single loan
                                  Maximum range of interest            The loan with the highest Loans in a single lender pool
                                  rates                            interest rate can be no more          must all have the same
                                                                       than 2 percentage points interest rate; interest rates on
                                                                     above loan with the lowest loans in a multi-lender pool
                                                                                    interest rate. must be within 1 percentage
                                                                                                              point of each other.
                                  Sources: SBA and Ginnie Mae.



Fees Per Dollar of Loan Are       Over $500 billion in MBS guaranteed by Ginnie Mae is currently
                                  outstanding. Ginnie Mae approved lenders issue MBS backed by cash
Lower in the Residential          flows from federally insured residential mortgages. Ginnie Mae’s fee of 6
Mortgage Than the 7(a)            basis points covers its guarantees for timely payment of principal and
Secondary Markets                 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.




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




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
                                                     36
principal balance for servicing the mortgage loans. 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.




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




MBS Are More Liquid Than     A financial market is more liquid if market participants can buy, sell, and
                             resell large amounts of holdings without affecting the prices of traded
7(a) Pool Certificates and   securities. In 1997, the dollar amount of resold Ginnie Mae guaranteed
Securities                   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
Conclusions                  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.




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




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



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




                      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
Agency Comments and   comments on a draft of this report, which are summarized below and
Our Evaluation        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.




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




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



Letter                                                                                                 1


Appendix I                                                                                            38
                          The Unguaranteed 7(a) Secondary Market Is Newer and                         38
The Unguaranteed 7(a)       Smaller Than the Guaranteed 7(a) Secondary Market
Secondary Market          7(a) Securities Are Issued in Private Placements or                         40
                            Through Public Offerings
                          Securities Rating Agencies Help Determine How 7(a)                          41
                            Securities Are Structured
                          In Approving 7(a) Securities, SBA Seeks to Ensure the                       43
                            Safety and Soundness of the 7(a) Program


Appendix II                                                                                           46
                          The Guaranteed Secondary Market                                             46
The Guaranteed 7(a)       SBA Has Specific Requirements for Formation of Loan                         46
Secondary Market            Pools Backing 7(a) Certificates
                          Pool Certificates are Based on Loan Pools                                   46


Appendix III                                                                                          50

SBA Guaranteed Pool
Certificates and Ginnie
Mae MBS Are Exempt
From SEC Registration
and Reporting
Requirements
Appendix IV                                                                                           53

Comments From the
Small Business
Administration
Appendix V                                                                                            55

Major Contributors to
This Report


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




Tables    Table 1: Residential Mortgages and Portions of 7(a) Loans                      20
            Originated and Sold in Secondary Markets in 1997
          Table 2: Characteristics of the Guaranteed 7(a) and                            30
            Ginnie Mae Secondary Markets


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




          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




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

The Unguaranteed 7(a) Secondary Market


                        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
The Unguaranteed 7(a)   newer and smaller than that for the guaranteed portions. SBA first
Secondary Market Is     authorized the sale of unguaranteed portions of 7(a) loans on the
Newer and Smaller       secondary market in 1992, 8 years after pooled guaranteed portions were
                        authorized to be sold. Recognizing that nondepository institution lenders
Than the Guaranteed     lack customer deposits to fund their 7(a) lending, SBA initially allowed
7(a) Secondary Market   only those lenders to securitize their unguaranteed portions. In 1997,
                        about $290 million in unguaranteed portions of SBA loans were sold on the
                                                                           1
                        secondary market compared to $2.7 billion dollars 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
                                                                                              2
                        by the Board of Governors of the Federal Reserve System and SEC, 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.




                        Page 38                                 GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                           Appendix I
                           The Unguaranteed 7(a) Secondary Market




                           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.

Securitizations in the     Several factors could lead to increased issuance of securities backed by
                           the unguaranteed portions of SBA loans, as follows:
Unguaranteed 7(a) Market
Could Increase             (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




                           Page 39                         GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                            Appendix I
                            The Unguaranteed 7(a) Secondary Market




                            (5) ongoing improvements in understanding and underwriting small
                                                                   3
                            business loans, such as credit scoring, 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
7(a) Securities Are         pooling and sale of those portions to a bankruptcy-remote special purpose
Issued in Private                          4
                            vehicle (SPV). Securities backed by unguaranteed portions of 7(a) loan
Placements or Through       portions are issued and sold to investors in either a private placement or
                            public offering. Investors receive an ownership interest in the right to
Public Offerings            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
                                                                                              5
                            most risk-averse investors look for an investment-grade rating 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.

Public Offerings of 7(a)    Securitizations offered for public sale must be registered with SEC and
                            meet its requirements for disclosure of information relating to the
Securities Must Meet SEC    securities. The Securities Act of 1933 (the Securities Act) and the
Requirements for            Securities Exchange Act of 1934 (the Exchange Act) require securities’
Disclosure of Information   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.




                            Page 40                                  GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                              Appendix I
                              The Unguaranteed 7(a) Secondary Market




                              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.

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

Measured in Dollars, Public   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
Offerings Accounted for       traded, registered securities, while the other eight have sold their
Most Activity                 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 Rating             securities should be structured and priced to appeal to investors. To
Agencies Help                 understand how securities rating agencies approach the rating of SBA
Determine How 7(a)            loan-backed securitizations, we reviewed reports on this subject published
                                                                                        9
                              by Moody’s Investors Service and Standard and Poor’s. According to the
Securities Are                reports, the agencies estimate the ability of a transaction to pay interest
Structured                    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.




                              Page 41                                    GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                               Appendix I
                               The Unguaranteed 7(a) Secondary Market




                               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
                                                                                         10
                               the pool also play a role in loss performance analyses.

                               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.

All 7(a) Securities Have       As mentioned earlier, SBA 7(a) securities are usually structured in classes
                               that provide differing streams of interest and principal payments,
Used Subordination and         reflecting securities holders’ differing priorities to, and allocable interests
Excess Spread As Credit        in, such payment streams. A typical two-class structure would have senior
Enhancements                   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
                                                                                                         11
                               that are set aside to provide the protection come from excess spread

                               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.




                               Page 42                                 GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                        Appendix I
                        The Unguaranteed 7(a) Secondary Market




                                                                                                               12
                        from the sale of both the guaranteed and unguaranteed portions. 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 Approving 7(a)       in the unguaranteed 7(a) secondary market is limited to ensuring that the
Securities, SBA Seeks   safety and soundness of the 7(a) program are protected before it approves
to Ensure the Safety    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
and Soundness of the    does for pools of guaranteed portions. SBA establishes requirements for
7(a) Program            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.




                        Page 43                                GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                           Appendix I
                           The Unguaranteed 7(a) Secondary Market




Existing Requirements to   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
Ensure the Safety and      consent, the lender must satisfactorily show that it is retaining an
Soundness of the 7(a)      economic risk in the unguaranteed portions—such as keeping a certain
Program                    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.

New Requirements to        As mentioned earlier, SBA initially allowed only its nondepository lenders
                           to securitize their unguaranteed portions. This reflected SBA’s recognition
Ensure the Safety and      that nondepositories do not have customer deposits to fund their 7(a)
Soundness of the 7(a)      lending. However, the October 1, 1996, Small Business Program
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



                           Page 44                         GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
  Appendix I
  The Unguaranteed 7(a) Secondary Market




• 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.




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

The Guaranteed 7(a) Secondary Market


                        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
The Guaranteed          guaranteed portions of individual loans were sold. In 1984, Congress
Secondary Market        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
SBA Has Specific        portions must meet. Each pool must have at least four loans with a
Requirements for        minimum aggregate principal balance of at least $1 million. No single loan
Formation of 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
Pools Backing 7(a)      all variable rate loans. If the pool has variable rate loans, all loans must
Certificates            have the same rate adjustment dates. The pool’s interest rate is based on
                                                                    1
                        the loan with the lowest net interest rate, 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
Pool Certificates are   $25,000. Each pool certificate has a unique number, called a Committee on
Based on Loan Pools     Uniform Securities Identification Procedures (CUSIP) number, for
                                                 2
                        identification purposes. They are backed by the full faith and credit of
                        the U. S. government and have a timely payment guarantee from SBA. SBA
                                                                          3
                        does not charge for its timely payment guarantee, 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.




                        Page 46                                     GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                               Appendix II
                               The Guaranteed 7(a) Secondary Market




                               purchased loans. As with other government guaranteed securities, these
                               securities are exempt from SEC registration and reporting requirements.

Pool Assemblers Form Loan      Pool assemblers acquire the guaranteed portions of SBA 7(a) loans from
                               lenders, create the pools, and issue pool certificates through Colson
Pools and Issue Certificates   Services Corp., SBA’s fiscal and transfer agent. SBA must approve all pool
                               assembler applicants. SBA criteria require applicants to be in good
                               standing with SBA, any state or federal regulatory bodies that govern their
                               activities, and the National Association of Securities Dealers, if members.
                               They must meet certain net worth requirements and must have the
                               financial capability to assemble acceptable and eligible loans in sufficient
                               quantity to meet the requirements for issuing pool certificates. Federal- or
                               state-chartered banks and savings and loan associations, insurance
                               companies, credit unions, SBLCs, and broker-dealers can all become pool
                               assemblers as long as they meet these requirements.

The Fiscal and Transfer        Colson Services Corp., based in New York City, is SBA’s fiscal and transfer
                               agent for secondary market transactions involving both individual 7(a)
Agent Has an Active Role       loans and pooled guaranteed portions. For each transaction, Colson issues
With Pool Certificates         a certificate and sets the beginning balance, interest rate, maturity,
                               payment schedule, and issue date once it has determined that the issuer or
                               seller has provided the necessary documents to support the transaction.
                               Colson delivers the certificates to the registered holders (investors or their
                               designee). Colson maintains a registry of registered holders and the
                               current outstanding principal balance of each certificate. Borrowers pay
                               lenders, who take out their fees and other portions of the payments due
                               them and forward the remainder to Colson. Colson then makes principal
                               and interest payments to the registered holders. It also sends statements
                               to registered holders on the status of each pool backing their certificates.
                               When a pooled loan prepays or defaults, Colson forwards each registered
                               holder its pro rata share of the prepayment or SBA’s guaranty purchase.
                               Colson’s fee is one-eighth of 1 percent of the outstanding balance per year
                               for its services, which it collects by retaining a portion of the lender’s
                               payments.

SBA Has Disclosure             SBA requires the seller to disclose certain information to the buyer before
                               all initial sales and subsequent sales (transfers) of guaranteed pool
Requirements for Both          certificates and individual loan certificates. The seller must disclose a
Guaranteed Pool                yield calculation and the prepayment rate assumptions on which the yield
Certificates and Individual    calculation is based; the scheduled maturity date; the price to be paid by
Loan Certificates              the buyer, both in dollars and as a percentage of the par or principal loan
                               amount; the dollar amount of premium or discount associated with the
                               sale price; and the interest rate (the base rate and the differential for



                               Page 47                         GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
                              Appendix II
                              The Guaranteed 7(a) Secondary Market




                              variable rate loans). The seller must also disclose investment
                              characteristics, such as the fact that (1) SBA guarantees timely payment of
                              principal and interest on pool certificates, but not on individual loan
                              certificates; (2) SBA will purchase the guaranteed portion of individual
                              loans after 60 days of default by the borrower; (3) SBA does not guarantee
                              premiums paid for certificates; and (4) the loan or pool may be prepaid
                                                          4
                              prior to the maturity date.

                              Through its disclosure requirements, SBA seeks to provide investors with
                              an annual constant prepayment rate (CPR) based on the seller’s analysis of
                              the prepayment histories of SBA guaranteed loans with similar maturities
                              and with information on the certificates’ terms, conditions, and yields.
                              Colson provides a summary report of CPRs of pools with similar
                              maturities, which is attached to each guaranteed pooled certificate issued.
                              Investors can compare the CPRs represented by their seller with that
                              reported for similar sales. Colson updates the summary information each
                              month on a rolling 6-month basis. SBA officials believe this system keeps
                              the CPR information current and useful to investors and other market
                              participants. SBA guaranteed certificates are generally marketed to
                              institutional investors, such as pension funds and insurance companies.

                              SBA has authorized Colson to make available to subscribers a data tape
                              containing the payment history of every SBA 7(a) loan sold since 1985, the
                              time Colson has functioned as fiscal and transfer agent. To maintain
                              borrower confidentiality, Colson eliminates identifying loan numbers and
                              zip codes and provides a dummy number for each loan.

Broker-Dealers Selling        Individuals or organizations must meet certain requirements before they
                              are permitted to act as brokers or dealers in initial sales or transfers of
Guaranteed Portions Must      guaranteed certificates on either individual loans or pooled loans. They
Meet Certain Requirements     must be regulated by a state or federal financial regulatory agency or SBA,
                              or be a member of the National Association of Securities Dealers.

Lenders Service Loans After   SBA regulations require lenders to retain responsibility for all loan-
                              servicing activities, including those for loans sold in the secondary market.
Selling Them on the           SBA regulations allow lenders to earn fee income for servicing its small
Secondary Market              business loan portfolio when the guaranteed portions have been sold in the
                              secondary market. By retaining servicing responsibilities, lenders can also
                              maintain long-term relationships with their customers. A lender services
                              its loans by continuing to collect principal and interest payments from
                              borrowers and managing the collateral. The lender must forward monthly
                              4
                                  A buyer may prepay a SBA 7(a) loan at any time without penalty.




                              Page 48                                  GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Appendix II
The Guaranteed 7(a) Secondary Market




payments from borrowers to Colson along with a complete accounting of
the funds.




Page 49                         GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Appendix III

SBA Guaranteed Pool Certificates and Ginnie
Mae MBS Are Exempt From SEC Registration
and Reporting Requirements
               The Securities Act of 1933 (the Securities Act) and 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 registration and disclosure
               requirements. The required disclosures are contained in a prospectus or
               offering statement that is distributed in connection with the offer and sale
               of a security. The Exchange Act requires continuing disclosure after a
               security is issued. Certain publicly traded securities are exempt from the
                                                                              1
               registration and reporting requirements of the Securities Act as well as
               from the continuing reporting requirements of the Exchange Act. For
               example, securities issued or guaranteed by the United States, its agencies,
               and corporate instrumentalities are exempt. Offerings of exempt
               securities, however, are subject to the antifraud provisions of the federal
               securities laws, which provide generally that offering materials shall not
               contain an untrue statement of a material fact in connection with the offer
                                     2
               or sale of a security.

               This exemption includes securities guaranteed by SBA and Ginnie Mae as
               well as securities issued by most government-sponsored enterprises, such
               as Fannie Mae and Freddie Mac. The sale of the guaranteed portions of
               7(a) loans in the secondary market also is exempt from these provisions in
               the Securities Act and the Exchange Act because of SBA’s unconditional
               guarantee. SBA provides investors an unconditional guarantee to pay
               principal and interest, including interest accrued to the date SBA honors
               its guarantee, on the guaranteed portion of each 7(a) loan that goes into
               default. Pooled certificates also contain a timely payment guarantee from
               SBA to make scheduled payments to investors in the event of default.

               SBA, Ginnie Mae, Fannie Mae, and Freddie Mac all issue or guarantee
               exempt securities that are sold in different types of offerings. For example,
               SBA pooled certificates typically are backed by up to 25 SBA-guaranteed
               loan portions and marketed by pool assemblers to a small number of
               institutional investors. Investors in SBA-guaranteed securities receive
               required disclosures on the terms, conditions, and yield of the pool that
               they are purchasing. For example, with regard to prepayment risk
               information, the fiscal and transfer agent tracks and provides a summary
               report of constant prepayment rates (CPR) of similar maturities, which is
               to be attached to each guaranteed pooled certificate issued. Ginnie Mae

               1
                For an instrument to be exempt from registration, it either must constitute an exempt security, be
               sold in an exempt transaction, or not be classified as a security.
               2
                The pools of guaranteed portions also are exempt from registration under the Investment Company
               Act of 1940. See SEC No-Action Letter, 87-210-CC (April 13, 1987).




               Page 50                                GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Appendix III
SBA Guaranteed Pool Certificates and Ginnie Mae MBS Are Exempt From SEC Registration
and Reporting Requirements




guaranteed MBS are backed by larger mortgage pools and sold in public
offerings to a large investor market. The offering materials for Ginnie Mae
securities includes the issuer, the principal amount of loans in the pool,
whether the loans backing the pools are fixed- or adjustable-rate, the
interest rate, and the maturity date. Fannie Mae and Freddie Mac MBS are
typically issued in public offerings in which investors receive offering
materials that contain detailed information about the loan pools.
According to enterprise officials, the information provided by Fannie Mae
and Freddie Mac is similar to that provided by MBS issuers who are not
exempt from SEC registration and reporting requirements.

With regard to the securitization of the unguaranteed portion of 7(a) loans,
an SBA lender may issue a security that is backed by the cash flows from
the unguaranteed portions. These securities are not covered by the same
exemption as the guaranteed portion securitizations because an SBA
guarantee is not present. Accordingly, when these securities are publicly
offered and traded, they are subject to SEC registration and reporting
requirements. Therefore, issuers are required to comply with registration
and reporting requirements in the federal securities laws unless they rely
on another exemption from registration, such as the private placement
exemption. In a private placement, the issuer can avoid the costly
registration and reporting process if the transaction by the issuer does not
                           3
involve a public offering. Administrative and judicial decisions provide the
criteria for determining whether a transaction does not involve a public
          4
offering. In addition, in order to minimize the uncertainty about the
reliance on the private offering exemption, SEC has a safe harbor rule that
provides more objective standards. If the rule is properly followed, the
                                                        5
issuer is assured the availability of the exemption. Many corporate
securities issuers use the private placement market. One of the
characteristics of a private placement, however, is that the investor cannot
easily resell the security; that is, the security is less liquid than a publicly
traded security. Of the nine issuers to date of securities backed by the
unguaranteed portion of 7(a) loans, one has issued publicly traded,

3
    15 U.S.C. §77d(2).
4
 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 on 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.
5
 See regulation D (17 C.F.R. §230.501-08). Regulation D permits the sales of interest to an unlimited
number of accredited investors (as defined in rule 501) but limits sales to 35 or fewer nonaccredited
investors.




Page 51                                 GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Appendix III
SBA Guaranteed Pool Certificates and Ginnie Mae MBS Are Exempt From SEC Registration
and Reporting Requirements




registered securities, while the other eight have sold their securities
through private placements.




Page 52                         GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Appendix IV

Comments From the Small Business
Administration




              Page 53   GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Appendix IV
Comments From the Small Business Administration




Page 54                         GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Appendix V

Major Contributors to This Report


                        William B. Shear, Assistant Director
General Government      Melvin Thomas, Evaluator-in-Charge
Division                Darleen Wall, Senior Evaluator
                        Mitchell B. Rachlis, Senior Economist
                        Desiree Whipple, Communications Analyst

                        Rosemary Healy, Senior Attorney
Office of the General
Counsel




                        Page 55                   GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Page 56   GAO/GGD-99-64 Size of the SBA 7(a) Secondary Markets
Ordering Information

The first copy of each GAO report and testimony is free. Additional
copies are $2 each. Orders should be sent to the following address,
accompanied by a check or money order made out to the
Superintendent of Documents, when necessary. VISA and
MasterCard credit cards are accepted, also. Orders for 100 or more
copies to be mailed to a single address are discounted 25 percent.

Order by mail:

U.S. General Accounting Office
P.O. Box 37050
Washington, DC 20013

or visit:

Room 1100
     th                  th
700 4 St. NW (corner of 4 and G Sts. NW)
U.S. General Accounting Office
Washington, DC

Orders may also be placed by calling (202) 512-6000 or by using fax
number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and testimony.
To receive facsimile copies of the daily list or any list from the past
30 days, please call (202) 512-6000 using a touch-tone phone. A
recorded menu will provide information on how to obtain these
lists.

For information on how to access GAO reports on the INTERNET,
send e-mail message with “info” in the body to:

info@www.gao.gov

or visit GAO’s World Wide Web Home Page at:

http://www.gao.gov
United States                       Bulk Rate
General Accounting Office      Postage & Fees Paid
Washington, D.C. 20548-0001           GAO
                                Permit No. G100
Official Business
Penalty for Private Use $300

Address Correction Requested




(233543)