Despite what many analysts view as compelling logic, securitization of small-business loans remains meager. Because small-business loans lack the standard characteristics of other, more widely securitized assets, securitization is likely to remain limited.
Ron Feldman, financial specialist in the Federal Reserve Bank of Minneapolis' banking supervision department, sees some growth on the horizon, but says it may not be uniformly positive for banks or for credit availability.
Following are edited excerpts from an analysis by Mr. Feldman in the September issue of The Region, a publication of the district bank.
The rapid increase in the securitization of nonmortgage loans has been driven by market forces. More specifically, the explosion in securitization is partly due to the many benefits it produces for borrowers, investors, and lenders, and partly due to technological innovations that lowered the costs of securitizing loans.
However, despite all of the potential advantages, small-business loans have been resistant to securitization. Although exact numbers are not available, it appears that less than $900 million in small-business loans have ever been securitized, while an estimated $155 billion in such loans were outstanding at yearend 1994. (This) means that either the benefits of small-business securitizations are less significant than those of other nonmortgage loans, or the costs associated with securitization remain comparatively high for these types of loans, or both.
The benefits of small-business loan securitizations are similar to those of other assets. Former Federal Reserve Governor John LaWare testified before Congress that securitization could increase credit to small businesses, provide liquidity, fee income, and asset diversification for banks and reduce their capital requirements, and offer investors a low-risk security with attractive returns.
The primary retardant to growth seems to be cost. Determining the expected cash flows from a pool of small-business loans remains comparatively costly. These costs are driven by the need for information on specific borrowers and local conditions; the lack of standardization of loan terms; and the lack of long-term performance data. ... Given the other investing options, investors have been reluctant to take on the risk and cost of investing in small-business loan pools. ...
Nonetheless, policymakers have offered several plans to jump-start this market. One recently enacted law would reform current regulatory policy. Another plan would make better use of existing information that the government collects on small-business loans. Neither plan is likely to lead to significant growth of this market.
Bigger increases in small-business loan securitization could be achieved by using public resources to absorb the costs of these transactions. However, such government intervention would not improve the use of society's resources. In contrast, market actors are developing initiatives that could build the infrastructure and lay the groundwork for significant growth.
President Clinton signed legislation in September 1994 which, in part, sought to increase the amount of credit flowing to small businesses by encouraging the growth of securitization.
The Riegle Community Development and Regulatory Improvement Act of 1994 took two steps to achieve this goal. It granted favorable regulatory treatment to securitized small-business loans (for example, it waived some restrictions on investing securitized loans) and it made changes in capital requirements to reduce the capital that banks selling small-business loans have to hold.
This legislation recognized that high transaction costs were the primary cause of limited small-business loan securitization. Indeed, the legislation could lead to more small-business securitizations by reducing regulatory costs. However, the legislation does not reduce the far more significant informational costs associated with purchasing securitized loans. Thus, it is unlikely to lead to major volume increases in this market.
The government has other means of reducing the costs of these transactions.
One proposal is the creation of a federally chartered, but privately owned, corporation that would guarantee payment in securities backed by small-business loans. Like other government-sponsored enterprises such as the Federal National Mortgage Association or Federal Home Loan Mortgage Corp., the corporation would have the implied financial support of the federal government. As a result, its guarantee would almost eliminate default risk on small-business loan securities. Investors would no longer need to use resources to analyze the loan pools, and loan sellers would no longer need to provide loss protection.
The risks associated with these transactions would not have been reduced, but would be transferred to federal taxpayers who support the corporation's guarantee. Such a shift could benefit society if the corporation were able to more efficiently judge and bear the risks posed by the loan pools.
But the corporation would have no competitive advantage in these regards and, as a pseudo-public entity, would have less incentive than private parties to diligently monitor potential costs. In addition, the creation of this corporation, with its federal support, could greatly curtail private innovation in this market.
To reduce information costs, federal agencies that already interact with small-business loans or lenders could allow market participants to better exploit their contacts or data. For example, the Small Business Administration could make more widely available its historical records on the loan repayment experience of SBA-guaranteed loans.
The Office of the Comptroller of the Currency has proposed a program in which banks could request a summary of how a bank's evaluation of credit correlates with the agency's credit grading of the same loans. The Comptroller's office would then produce an "agreement table." The requesting bank could then pass out these tables to investors to help them translate issuing-bank credit terms into more familiar terms.
These programs have the advantage of adding few new costs, as the agencies would already perform these functions. Both programs would also directly address informational concerns.
Yet, if enacted, these plans are unlikely to greatly increase the number of small-business loan securitizations. The SBA data may not be relevant for investors in evaluating loans not underwritten to SBA standards. The Comptroller's office would not be able to provide historical loss information for its loan classification system. Thus, investors will not be able to use these classifications to determine expected payouts from a pool of loans.
As Federal Reserve Chairman Alan Greenspan noted in a speech to the American Bankers Association in 1994, the substantial benefits of securitization provide ample incentive for market participants to develop means to reduce the information costs of assessing a pool of these loans. In particular, the advantage of holding a security backed by a well- diversified pool of loans, instead of a single loan, should spur cost reductions.
Moreover, competitors to banks that already fund their activities by issuing securities have a natural incentive to find new sources of funding and are likely to lead the development of this market. Experience with other assets that were once considered hard to securitize (e.g., credit card receivables) suggests these hurdles can be overcome.
It seems certain that small-business loan securitization will grow in the long run. But it is less clear that this form of financing will be as dominant as it is or will be in other loan sectors. Furthermore, while the growth of small-business loan securitization should indicate the reduction of transaction costs, a higher volume of such securitizations will not produce net benefits for some banks or borrowers. For example, the increase in these transactions may not lead to additional credit to small businesses and may actually increase costs for some. The effect of this trend on bank profitability will also vary a great deal.
Standardization would bring down the costs of analyzing these loan pools, but there are some attributes of small-business operations and banking relationships that may inhibit standardization or low-cost analysis over the long term.
Many small businesses and banks will resist standardization because the small businesses' credit needs vary more than most other borrowers' and bank underwriting criteria for small businesses are, as a result, quite heterogeneous. Some small-business borrowers may prefer, and in some circumstances need, lenders that are willing to maintain ownership of the loan and engage in frequent loan restructuring.
Securitization will allow lenders that are particularly efficient at one or more aspects of lending to generate fee income that matches or exceeds the revenue from holding small-business loans. For example, community banks may continue to have an advantage in originating and servicing loans to local, smaller firms because of their knowledge of local conditions and of firms' special characteristics, like quality of management. These banks could compete with nonbank lenders and they could continue to profit even if they sell their loans.
Securitization could also allow community banks to originate loans, such as longer-term loans, that they would not make if they were not able to sell.
However, other banks' profitability could be hurt by the rise of small- business loan securitization. For example, banks would find new competition to originate loans from nonbank competitors. Not only could banks originate and service fewer loans due to competition, but with information easier to process, the loans in which they are involved may produce less revenue. With a more-standardized loan product, some banks could no longer have comparative advantages in making loans to small firms.
In the end, the market for securitizing small-business loans will certainly grow over the next several decades without additional government assistance, as market participants lower transaction costs while exploiting benefits. The effect of this growth, though, will not be uniform or be viewed as an improvement for all small-business borrowers or lenders.