There are three ways to grow a profitable loan portfolio. One is by originating loans within your field of membership, or through the CUSOs you belong to. Another is to purchase participation loans. And the third is to purchase government guaranteed loans. Here is some information that can help you succeed with methods two and three.
- Like participation purchase, individual, government guaranteed loans go on your loan portfolio along with participations.
- Like most participation purchases, these loans are serviced for you. You get a monthly statement and an ACH transfer or check.
- Unlike participations, the part you buy with an SBA or USDA guarantee is guaranteed as to principal and accrued interest, irrevocably, by a corporation of the U.S. government. Thus, unlike participation loans, guarantees have no (zero) principal risk and zero accrued interest risk. They are repurchased, at par, by the SBA or USDA or other agency in event of default. The servicer deals with the borrower – and with the SBA and USDA.
- Guaranteed loans trade at a substantial premium and hence carry the risk that they might pay off before you have amortized the premium. Clearly, premium risk is a lot less than risking default on an entire loan – but it is a loan selection risk you can largely protect yourself against by reviewing the underlying loan against the default rates published for each and every business classification – data the SBA has been collecting for nine years.
If a loan defaults or prepays early any unamortized premium will have to be immediately amortized.
The breakeven point is the point at which your cash flow after cost of funds exceeds the premium you paid for the loan. For example, if you pay a 6% premium for the guarantee and the net coupon is 4.6%, and your cost of funds for three months is about 60 basis points, your breakeven point is:
4.60% Net Coupon after Servicing (adjusts every three months with no caps)
-.60% Cost of Funds
=4.00% Effective
BEP = 6.00% / 4.00% = 1.5 years
So, if the loan stays 1.5 or more years, you are ahead of the game and there's not a cash loss for an early prepayment. Moreover, on USDA credits, you (the investor) get to keep the prepayment penalty, which is often quite substantial, in event of a voluntary payoff. On SBA deals, the SBA keeps the penalty.
The most popular and widely traded government guaranteed loans are SBA 7A guaranteed loans (individual loans and pools) and USDA guaranteed loans.
The maximum SBA 7A loan is $5 million. Loans can now be guaranteed to a maximum amount of 75% of the outstanding principal, so the maximum guarantee is $3.75 million. The originating lender keeps the non-guaranteed portion and services the loan. .
Most SBA 7A loans adjust monthly or quarterly. Some are fixed for three to five years, or for the term. These are called “orphans” as they are not included in pools, which are pass-through securities. They all pay monthly. Most have a high cap on the rate or no cap at all.
Typically, the USDA guarantee is fully amortized over a term of up to 25 years. Terms are shorter if the collateral is equipment. The rate may be fixed for one to 10 years, then adjust quarterly over Prime or LIBOR, or adjust every three or five years. Or, the loan may adjust monthly or quarterly from the very start of the term.
Government guaranteed loans are rated as a low-risk asset because the secondary (as opposed to primary) market guarantee cannot be taken away. “This is an unconditional guarantee to the investor or registered holder regardless of the actions of the originating lender,” writes the SBA's counsel in commenting on 51 Comp.Gen 474, interpreting Section 5 of the Small Business Act, known as 15 USC 634.
In sum, USDA and SBA guarantees are an asset class unique for credit unions – they grow the loan portfolio, but in other respects are treated as securities. They carry substantial premium risk – a risk which can be understood and analyzed during the loan selection process. They yield much less than participation loans, but far more than agencies. And for many credit unions, they are a handy way to grow outstandings without principal risk.
Tim Thomas is vice president of lending at the $76 million Credit Union of the Rockies in Golden, Colo.
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