Bear Stearns Innovations Expand Loan Market

NEW YORK - The secondary market for loans guaranteed by the Small Business Administration has changed dramatically over the past decade.

Started in the early 1970s as an informal trading of loans between banks, the market got a push in 1984 when Congress gave the agency authority to pool the guaranteed portion of loans it backed. Since then, the market has grown at a 21.6% compounded annual rate.

At yearend, the market was expected to be just below the record $2 billion sold in 1993.

"We've always had a good product," said Gordon Lindsay, a senior managing director at Bear, Stearns & Co., one of the leading players in the growing market.

Indeed, the securities became so popular that investors often were willing to pay premiums of 15% or more over par. Those premiums left many potential investors out in the cold though.

To eliminate the premiums, the market and the SBA attempted to change the product. The SBA imposed a 50% tax on premiums above 10%, while pool assemblers - including Bear Stearns - developed securities that stripped some interest from the loans and sold them separately.

In a recent interview, Mr. Lindsay, who heads the firm's SBA securities division, talked about the outlook for the market, efforts to create a market for unguaranteed business loans, the growth of interest-only securities, and how investors may react to a funding shortfall at the SBA.

Q.: What have been the factors that have contributed to the success of this market over the years, and what factors have stunted its growth?

LINDSAY: We've always had a good product. Full-faith-and-credit securities with a floating rate, and mostly uncapped. There are not many things you can buy that combine those three things for investors. For that reason they have become a proxy for other full-faith-and-credit investments - like T-bills, government repos.

If you look at the yield pickup over those instruments, SBAs look very attractive. The problem was, you had to buy individual loans at significant premiums. So if we're buying at prime plus 1% and paying 110 to 115, which were the kinds of premiums that existed at that time, obviously we had to sell it at something north of that.

Q.: How did the market react to that?

LINDSAY: That was the real problem. The pricing just wasn't in keeping with the conservative structure of the underlying pooled product. So about three years ago we really made a big change by stripping out enough interest from each loan so that now we can sell the pool at par.

It's obviously a lower coupon. Instead of selling at prime plus 1%, we're now selling at prime minus 2% to 2.5%. That is now being sold separately as an SBA interest-only strip. What you now have is a pool that has a pricing structure commensurate with the general risk quality of the security. A full-faith and credit security selling at 110 or 115 just was not something we could sell to many investors. A full-faith-and-credit security at par is a very attractive investment.

Q.: Are you using all types of SBA-backed loans for these securities?

LINDSAY: It's only happening right now on the long end of the market, in the real estate paper. Real estate collateral has a very stable prepayment profile. If you think about it, where can an SBA real estate borrower refinance his loan away from the SBA? We built a prepayment model for the real estate collateral. And that's what enabled us to sell the SBA interest-only security.

Q.: Who are the investors for these securities?

LINDSAY: The bottom line is, where you had one product that didn't work well for anyone - prime-plus-one paper that traded at significant premiums - now you have two products that work very well but for very different investors.

The investor buying the pool is typically the very conservative core portfolio investor who doesn't want the risk. So he's now able to buy at par. All the risk is attached to the IO (interest-only strip). That becomes essentially a fixed-rate investment that trades over the Treasury curve. And that goes to the investor who is looking for the risk. IOs go primarily to intermediate government bond funds.

Q.: Is there an active trading market in these securities or is it simply firms like yours that are buying loans, pooling them, and reselling the pools?

LINDSAY: I think compared to many other markets, you would consider SBA pools more of a buy-and-hold security. It's typically going to short-term, core portfolio asset managers who need full faith and credit collateral. They have really become comfortable with the paper and are typically holding it for fairly long periods of time. It's not a short-term trading instrument.

Q.: The National Association of Government Guaranteed Lenders is trying to put together an $80 million loan pool composed of the unguaranteed portion of SBA loans. Is it realistic to expect a thriving market to be created for unguaranteed loans?

LINDSAY: The only sales that have happened so far are from nonbank lenders. No bank has done one because heretofore they had a regulatory problem. Assuming that is removed, I would assume at some point you will start to see some banks getting involved in selling unguaranteed portions.

It certainly becomes more difficult when you get away from the single issuer. Remember, you have to really effectively collateralize the unguaranteed portion. I mean the SBA has allowed the Money Store only on the basis that they remain in a first-loss position. I don't know of any bank that has a big enough portfolio by itself, a la the Money Store.

Q.: Is a multilender pool a big step in broadening the market for securitized business loans?

LINDSAY: It becomes much more difficult to do when you have 10 or 20 participants. I'm not saying you can't do it, but it's obviously more difficult. Do you have it set up so that the collateral provided by each of the participants is segregated against their own reserves? I don't have the answer to that. I certainly think that's doable, but it's going to take time to create that structure. We have not been working on that here. We're trying to stay abreast of what NAGGL is doing, though.

Q.: What do you see happening to the prices of pool securities and loans in 1995?

LINDSAY: The pricing of uncapped pools has been incredibly stable with one exception, and that was about a year ago. We're offering prime minus 2% to 2.125% which is right around the par coupon now. That probably shifts a little bit, but that's the range.

And that was the range for quite a while. But a year ago, when prime stuck at 6%, all the other rates used as benchmarks - fed funds, government repos, bills - went down to 2.625% to 2.75%. So you had a huge spread between prime, and there were a number of large investors that really chased that further than they should have. They literally drove the coupon down to prime minus 2.375%.

Q.: Will there be a repeat of that?

LINDSAY: We don't think that will happen now. If you look at spreads between prime and these other short-term rates in a historical context, it will look good at a point in time. But I think the market on the investor side overreacted to that spread. I don't know that it has ever been wider than that. I don't think prime minus 2.375% looks attractive. I think the market got carried away at that point in time. We're back to prime minus 2% to 2.125%, which is probably where it should have stayed. But markets move.

Q.: How will the SBA's budget problems affect the secondary market?

LINDSAY: I think it's going to cause a choppiness in the market.

The problem is that in the past we have had situations where we have continually run out of funding on a periodic basis over the year. And it just creates a very choppy market for all the participants. The banks that have gone ahead and negotiated with the borrower can't get the money because there are no more dollars for that quarter. So they've got to wait. At the same time, we've got investors who are looking for a certain amount of flow. Everybody is stop-start. We get through it, but it's an unfortunate situation.

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