On May 18 the Small Business Administration unveiled its risk-based framework for the securitization of the unguaranteed portion of loans made through its section 7(a) program, the SBA's largest loan program. This new structure is a key element in the agency's strategy of delegating more authority to its private lending partners while putting incentives in place that ensure that the SBA's, its partners', and the taxpayers' interests are closely aligned.
Since the section 7(a) program was established in 1958 to assist qualified small businesses in obtaining access to capital, the SBA has relied upon a risk-sharing arrangement with participating lenders as the cornerstone of its risk management strategy. By requiring that lenders accept on average 27% of the credit risk of each loan originated through the program, the SBA has ensured that lenders have a financial stake in the performance of 7(a) loans.
This approach differs from many of the federal government's other large loan guarantee programs, such as the student loan and housing programs, where the government generally holds 100% of the credit risk.
In an unregulated environment, securitization of the unguaranteed portion of the 7(a) loans could have dramatically changed the SBA's risk- sharing arrangement. Commercial lenders would no longer be required to retain a direct financial interest in loans made through the 7(a) program.
According to the SBA, lenders with short time horizons or those lured by the immediate benefits of FAS 125 gain-on-sale accounting could be tempted to originate a higher volume of lower-quality loans, resulting in quick profits for the lender but higher losses over time for the government and taxpayers.
As a result of these concerns, when the SBA issued an interim regulation in April 1997 that opened the securitization of the unguaranteed portion of 7(a) loans to bank lenders, it required that all securitizers retain at least 5% of each loan (or about 20% of the unguaranteed portion).
While the interim regulation enhanced protection of the taxpayers, the uniform retainage requirement did not address the difference between good and poor performances by 7(a) lenders, leaving that to the sole judgment of the SBA. In addition, the SBA was authorized to approve securitizations that did not meet its 5% rule on an ad hoc basis.
The May 18 proposed final rule takes the next step of aligning the SBA's and its lenders' incentives by providing performance-based standards and establishing a framework that ensures lenders that all players will be treated equally. Through its "three-level unified approach," the SBA establishes consistent capital requirements for bank and nonbank securitizers, defines a performance-based retention requirement, and provides penalties for securitizers with low currency rates-i.e., high delinquency rates.
While 7(a) lenders may argue over the most appropriate performance measures, nearly every lender will agree that the SBA has taken a significant step in the right direction by establishing a risk-based framework.
In implementing this risk-based framework, the SBA lending community must examine the most crucial question in risk-based performance environment. Do the performance measures accurately gauge the underlying risk? For example, could there be instances where strong lenders still trigger the SBA's proposed currency rate standards and therefore lose their preferred-lender status?
Does a lender's chargeoff amount shown as a percentage of all loans originated over the past decade provide an accurate measure of historical lender performance? If not, what other measures better satisfy the SBA's proposed risk management framework?
As all parties explore these and other questions in the upcoming weeks, the SBA should be congratulated for establishing a general framework that meets its risk management needs while encouraging the continued expansion of access to capital for creditworthy small businesses.