Lenders this week objected to a government proposal that would prevent them from selling entire loans backed by the Small Business Administration.

A 1996 law instructed SBA to craft a rule that lets banks securitize the unguaranteed portion of 7(a) program loans to small businesses. Nonbanks have been permitted since 1992 to sell the 25% of these loans not backed by SBA.

But in February the agency proposed requiring all lenders to retain a 5% interest as a safeguard against defaults. Witnesses at an agency hearing Wednesday told SBA Administrator Aida Alvarez the move would drastically reduce the size and profitability of securitizations.

Representatives of banks and nonbanks argued the rule is not needed because they set aside reserves of at least 4% to cover any defaults, investors conduct due diligence, and investment rating agencies make sure loan portfolios can withstand losses many times higher than the lender's historic loss rate.

"The proposed rule would fundamentally alter the basic economics of securitization, to the detriment of both the SBA and an efficient capital market for small-business loans," said Morton Dear, chief financial officer of Money Store Inc.

But SBA officials fear that lenders-which can already sell the guaranteed portion of SBA loans-will not adhere to strict underwriting standards if they can sell entire loans.

"If the deal is structured in such a way the lender has no exposure, it would encourage them to make riskier credits," said James W. Hammersley, an SBA financial assistance administrator. That would increase the agency's chances of having to repay investors the guaranteed portion when borrowers default or the lender collapses, he said.

The American Bankers Association suggested that the SBA give lenders the alternative of taking full liability for the unguaranteed portion. That would "provide a strong incentive for the originating lender to underwrite its loans prudently," said Arthur C. Johnson, president of United Bank of Michigan.

SBA was required by Congress to have a rule in place by March 31. After missing that deadline, the agency in early April issued an interim rule that permits all lenders to securitize loans without retaining 5%.

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