The secondary market for Small Business Administration loans has dried up over the past few weeks, and that has forced active SBA lenders such as Unity Bancorp Inc. in Clinton, N.J., to make some tough business decisions.

The $864 million-asset Unity which started an aggressive expansion of its SBA lending a year ago, said last week that it shut down eight SBA loan offices in seven states outside its market area, and laid off 10 of its 12 SBA lenders.

"There's virtually no market left for SBA loans," said James A. Hughes, Unity's president and chief executive officer.

Investors have lost interest in buying securities backed by SBA loans because profit margins have shrunk. The cost of funds for these investors is pegged to the London interbank offered rate, while the loans are pegged to the prime rate. Libor spiked last month, making the SBA loans less attractive as investments.

At one point, "it was even higher than prime rate, and that was something that had never been seen before," said Bob Judge, a partner at Government Loan Solutions Inc. in Cleveland, a consultant to SBA lenders.

Libor has started to fall, but even if it snaps back to its historic levels, the backlog of SBA inventory would take a while to work out, Mr. Judge said. Moreover, investors have found that commercial mortgage-backed securities are much more attractive than the SBA loans these days.

"They're all trading at enormous spreads to Libor," Mr. Judge said. "SBAs can't compete."

Eric Zarnikow, the SBA's associate administrator for the office of capital access, said the agency is aware of the disruption in the secondary market.

He said the SBA is counting on the economic stimulus plan to reinvigorate lending, which has fallen off sharply. Loan volume for August and September fell more than 50% from a year earlier, and was on pace for a 50% decline this month as well.

About half of SBA lenders hold the loans on their books, Mr. Zarnikow said. The other half — mostly small banks and nonbank lenders — sell them.

"We're beginning to hear some lenders indicate that secondary-market liquidity is a concern, and that it may begin to impact their ability to lend," he said.

The $650 million-asset Community South Bank in Parsons, Tenn., has been a large lender of both 7(a) and 504 loans. At the start of the year it had begun to focus more attention on 7(a) loans, because the disruption in the securitization market had already crimped demand for 504 loan sales, said Scott Thomas, the executive vice president for Community South's small-business lending division.

But now the market for 7(a) loans is disappearing, as those that pool the loans cannot sell them and do not have the capacity to buy more, Mr. Thomas said. "Within four weeks, it was backed up. Some firms even refuse to bid at the present time."

Community South began holding the loans on its books when the premiums offered by buyers dropped sharply, because "it makes no sense to sell them," Mr. Thomas said.

But that is only a temporary solution— "we're a small bank and we can't do that forever," he said — so Community South is slowing its loan production.

Several lenders said they could sell SBA loans to investors at an 8% to 10% premium a few years ago.

The premium contracted to 4% to 6% last year and to 1% to 3% over the past month.

Now lenders are lucky to get a bid at all.

Unity's Mr. Hughes said when his company would sell its SBA loans in the past, bids typically would come in from eight or nine potential buyers.

"One by one they've been dropping out," he said. "And with the bids that we're getting, there's no profit left in it."

Unity has been one of the most active SBA lenders among community banking companies in recent years. It generated about $75 million in 7(a) loans during the SBA's 2008 fiscal year, which ended Sept. 30.

But Mr. Hughes said he expects its volume to drop, "probably to well under $20 million," this fiscal year.

ICBA Securities, a unit of the Independent Community Bankers of America, is among those that have stopped bidding on these loans, because it cannot sell them and does not have the capacity to buy more.

Jim Reber, the president and CEO of ICBA Securities, said it has two lines of credit, which it uses to buy the loans. But the institutions that extended the lines of credit want to shrink them.

He said ICBA Securities is not the only one in such a predicament.

"Most of us have been asked to limit our funding lines," he said. "We are befuddled by this, because there is no higher-quality financial instrument on earth than an SBA loan. It is backed by the full faith and credit of the United States government."

Industrywide, those that pool the loans have a backlog of about $3 billion worth, Mr. Reber said.

"The fallout is, because we can't pool the loans and buy them from the lender, in many cases the lender is not going to make the loan to the small business," he said. "So creditworthy small businesses are going without financing."

Meanwhile, many experienced SBA lenders are out of jobs. Community South has trimmed its staff of SBA lenders in 40 states by two-thirds, to about 50 people, over the last few months.

Neal Gordon, a partner at Gordon Hughes & Associates in Rockaway, N.J., said a conservative estimate is that 40% of those employed in SBA lending a year ago are out of work now, with no prospects for getting another job in their market.

"The industry has contracted tremendously," he said. "Nobody is hiring."

His firm, which specializes in headhunting for SBA lenders, has started to offer coaching services to help individuals figure out what to do next. "I'm getting calls daily and there's no place for them," he said.

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