SBA's biggest lender is overhauling its business model
The nation's biggest Small Business Administration lender is changing its stripes, and others could soon follow suit.
Live Oak Bancshares in Wilmington, N.C., became a Small Business Administration juggernaut adhering to a simple, powerful formula: Originate loans under the SBA’s flagship 7(a) loan-guarantee program, then rack up noninterest income selling them on the secondary market.
Recent challenges with SBA lending, including declining loan-sale premiums and the impact of rising interest rates, are causing the $3.4 billion-asset Live Oak to flip the script. After years of selling up to three-fourths of its 7(a) loan originations, the company now plans to hold twice as much production as it sells.
While Live Oak’s share price plummeted after the disclosure, industry observers said there is sound logic behind the move.
The strategy “makes a lot of sense — if you have a patient investor base,” said Bob Coleman, author of the Coleman Report, a long-running SBA newsletter. Coleman noted that lenders at a recent conference he sponsored said they were dealing with roughly 15% declines in loan-sale premiums.
Other sizable 7(a) lenders are likely facing pressures similar to those disclosed by Live Oak, Piper Jaffray's analysts wrote in a Dec. 6 note to clients. Secondary market pricing for SBA loan pools fell, on average, to 111% of par in October from 115% a year earlier, the analysts added.
Live Oak, in an investor presentation posted on its website, touted several long-term benefits to holding more of its 7(a) production. For starters, the move should help it quickly double in size, to more than $7 billion in assets.
At that point, management believes Live Oak can widen its net interest margin and lower its efficiency ratio to less than 60% from 72.8% on Sept. 30. Another goal is to boost the company's return on equity from 12.1% to 15% or higher.
Live Oak declined to discuss the effort beyond what it shared in the presentation.
The company is trading short-term pain for long-term gain, Aaron James Deer, an analyst at Sandler O'Neill, wrote in a Tuesday note to clients. “Eventually, this should produce more stable earnings for the company,” Deer added.
Other SBA lenders could make the same determination. Other factors could also come into play.
Given that banks that sell significant amounts of 7(a) volume tend to receive added scrutiny from the SBA, holding more loans could improve a lender's standing with examiners, said Jay Lucas, director of credit services at Porter Keadle Moore, an Atlanta accounting and advisory firm.
While he has noticed more interest in holding 7(a) loans, Lucas said plenty of banks will continue to sell "as long as premiums stay north 7% or 8%."
Overall 7(a) volume has also been declining after years of record volumes. Guarantees through the first seven weeks of fiscal 2019, which began Oct. 1, fell 12% from a year earlier, to $3 billion, according to the SBA.
“That’s inherently associated with a rising-rate environment, especially for startups,” Lucas said. “The payments are a big deal," so potential borrowers "are saying they have to think about this.”
Live Oak, for its part, has been broadening its base by adding conventional business lines. Last month, the company said it would create a unit to focus on commercial real estate.
“This is a new vertical that is sort of investor-owned with a focus more on shorter-term ... development deals, for the most part,” Angus McDonald, the unit’s general manager, said in a recent interview unrelated to the SBA disclosures.
The CRE unit will be a "conventional" businesses "intended to be outside the scope of" the SBA, McDonald said.
Live Oak is well aware it’s jumping into CRE late in the credit cycle.
“So we’re being very cautious,” McDonald said. “We’ll do $30 million to $40 million this year and probably ... a little [more] next year.”