Securitization of loans has been a key element dictating the business structure of mortgage lending, credit card issuance, and auto financing in recent years.
Small-business loans are one asset category that has not been securitized to a great extent, but I believe this will change in the coming years. As a result, the economics and strategies of small-business lending will be altered dramatically. To benefit from this expansion, bankers must understand the economic variables that will drive it, and the broader implications for their business.
Small-business loan securitization has been impeded by the nonuniform nature of the credits. The category encompasses a wide range of borrowers, from mom-and-pop stores, to professional practices, to software companies with $10 million in sales. The collateral ranges from home equity to inventory, receivables, and equipment. Many small-business loans are uniquely structured and customized, meaning there are no standard underwriting guidelines among lending institutions. Overcoming this heterogeneity of borrowers, collateral, and structures is the toughest challenge in securitizing these loans.
To understand why, we must look at the dynamics of the asset securitization process from the underwriter's point of view. When investment banks create securities backed by proceeds from a pool of loans, they must produce bonds that can be sold to investors at a sufficiently low yield to return adequate cash to the loan originators and a profit to the underwriters.
Investors, of course, will demand a level of yield that appropriately rewards them for the credit risk of holding the bonds. Bonds given a high credit rating, therefore, can be sold to investors with a lower yield.
The profitability of an asset-backed deal is often driven by the proportion of bonds that get double- or triple-A ratings. But the rating agencies will not award a lofty credit rating unless they can analytically demonstrate that the chances for default are truly remote. The process of statistically analyzing the default potential of the underlying loans tends to favor large pools of uniform loans that were originated using well- documented, time-tested credit standards.
When a loan pool is of lower quality or doesn't lend itself to straightforward statistical analysis, a double- or triple-A rating can be obtained only through "credit enhancement." This can take many forms, though for business-loan securitizations it has generally occurred through a certain level of recourse to the loan originator. Credit enhancement requirements have typically been the "show stopper" for small-business securitization deals, as the tough standards of the rating agencies for pools of heterogeneous loans have squeezed profit margins.
"Pools of standardized consumer loans can often receive a triple-A rating with little or no credit enhancement," says Stephen Deckoff, a principal at Black Diamond Advisors Inc., which specializes in the structuring and placement of asset-backed securities. "But the rating agencies are much tougher on business loans because of their nonstandard structure, documentation, and collateral."
Despite the complexity of small-business lending, I believe the forces favoring securitization are sufficient to drive lenders to adopt uniform underwriting standards and structures.
One of these driving forces is nonbank lenders' need for a deep source of funding and liquidity. And if loan demand accelerates and banks join nonbanks in facing liquidity constraints, the pace of securitization could pick up dramatically.
Securitization allows lenders to originate and service a much larger volume of loans than they could if they had to hold them in portfolio. The associated origination and servicing fees provide increased revenue without significant additions to assets.
Federal legislation such as the Community Development Financial Institutions Act of 1994 and the proposed Securitization Enhancement Act also will speed small-business securitization. Pools of loans would be able to be transferred to trust structures called "Fasits," which are modeled on the Remic structures in mortgage-backed securities. These trusts would be able to sell high-yielding subordinated bonds to investors without adverse tax consequences.
Since subordinated bonds provide credit enhancement to the other bonds issued by the trust by absorbing much of the underlying loans' default risk, it will be easier for originators to securitize loans without retaining residual liability (and capital) for default protection. However, since the subordinated bonds will sell at high yields, profit margins will be squeezed unless the amount of subordination required by the rating agencies can be minimized.
If we accept that securitization is likely to pick up, banks must assess the effect of this trend on overall strategy. Small-business loans would become increasingly standardized commodities, diminishing the competitive advantages banks enjoy from their special expertise and long-standing relationships.
Securitization would also reduce yields by standardizing the loans, pooling risks, and giving borrowers the ability to raise funds efficiently in the capital markets. Banks that wish to remain active in small-business lending may well be forced to originate loans that can be securitized, so they can participate in this higher-volume competitive business.
There are several considerations for banks to take into account as they begin the necessary learning process to compete in a very different business:
Origination volume. Larger pools of loans - $25 million to $100 million or more - lend themselves to more efficient securitizations. In larger pools, the statistical tests for determining ratings and credit enhancement requirements can be used with a greater degree of confidence. Small pools would have proportionately larger credit enhancement requirements. And underwriting fees and expenses, which can range from several hundred thousand dollars to $1 million, could not be absorbed as easily by a small pool. Because many institutions will be unable to originate the necessary volume of loans on their own, alliance and conduits will likely be formed to accumulate larger pools.
Uniformity. The need for common credit practices, documentation, and structures implies that originating institutions will have to be sensitive to emerging standards for credit scoring and documentation. It also means a loss of flexibility for lenders that have traditionally been able to offer small businesses the ability to restructure loans as circumstances changed during the loan term.
History. A documented track record of default experience, workouts and liquidations, monitoring, and servicing performance will be needed to rate the securities. Once again, better documentation is likely to lead to less need for credit enhancement.
"Many lenders that have been in business for years do not track loan performance and loss statistics by year of origination," says Mary Metz, senior director at Fitch Investors Service Inc. "These statistics would be helpful in determining credit enhancement levels."
Mr. Bernstein is a principal of Furash & Co., based in New York.