No. 227

 April 2003

SMALL BUSINESS

RESEARCH

SUMMARY

An Exploration of a Secondary Market for 

Small Business Loans

by Kormendi/Gardner Partners, 2002

[33] pages. Washington, DC 20036

under contract no. SBAHQ-01-C-0150 

This Small Business Research Summary (ISSN 1076-8904) summarizes one of a series of research papers prepared under contracts

issued by the U.S. Small Business Administration’s Office of Advocacy. The opinions and recommendations of the authors of this study do

not necessarily reflect official policies of the SBA or other agencies of the U.S. government. For more information, write to the Office of

Advocacy at 409 Third Street S.W., Washington, DC 20416, or visit the office’s Internet site at www.sba.gov/advo.

Small business policymakers have seen the development of a secondary market for small business loans

as a way of improving the flow of capital to entrepreneurs. In a secondary market, loans are pooled

together and packaged as securities for sale to

investors. This practice makes more capital available

by allowing lending institutions to remove existing

loans from their balance sheets, freeing them to

make new loans.

To help stimulate the growth of a secondary market for conventional small business loans, Congress

passed the Riegle Community Development and

Regulatory Improvement Act in 1994. The law was

intended to reduce the regulatory barriers to the

securitization of conventional small business loans.

Despite the Riegle Act, the growth of a secondary

market for conventional small business loans has

shown little progress during the past decade.

Several factors have hindered the emergence of a

secondary market during the past decade. The two

most important ones are the abundant supply of liquidity in the banking sector during the 1990s, which

has reduced the need for extra liquidity from the

public markets, and the lack of standardized loan

underwriting practices, which has made it difficult to

characterize the quality of the securities. This second

condition may be changing however, because of two

recent trends in the banking industry—the emergence of giant interstate bank holding companies and

the increased use of credit scoring as the basis for

loan approvals. The purpose of this report is to

examine the extent to which these trends may make

it easier for market participants to structure secondary

market transactions that use conventional small business loans as collateral, and ultimately, to provide an

additional source of liquidity for conventional small

business lending.

Overall Findings

The authors found that the increasing use of credit

scoring and the emergence of multibillion dollar

bank holding companies in the U.S. banking sector

have made the development of a secondary market

for conventional small business loans more likely.

There are two main reasons for this. 

• First, the availability of a large pool of small

business loans, especially small business credit lines

and possibly small business credit card loans, provides

a potential candidate for a secondary market since

these loans have been underwritten with credit scoring models that are relatively standard across lenders.

• Second, since investment banks and rating agencies “underwrite the underwriters” rather than the loan

pool alone, banking consolidation should improve

the feasibility of the securitization of small business

loans because of the emergence of large pools of loans

available for securitization from fewer originators.
Highlights

The study found that many large lenders are using

credit scoring to originate smaller loans, especially

for lines of credit of $100,000 or less. While the

application of credit scoring method in credit review

may create problems for certain borrower groups,

this development has resulted in a large pool of lines

of credit that are good candidates for the secondary

market because they are underwritten with relatively

standard scoring methods across lenders.

Since most major small business lenders continue

to use relationship underwriting rather than automated statistical scoring methods in making larger-sized

small business loans with collateral, these loans are

less likely candidates for securitization. Moreover,

even with industry consolidation, underwriting heterogeneity in larger small business loans remains

even within a large bank holding company. However,

since investment banks and rating agencies “underwrite the underwriters” as well as the loan pool,

banking mergers have increased the likelihood of the

securitization of small business loans. That is, as

banks merge, there are larger pools of loans available

for securitization from fewer originators, thereby

reducing the number of originators that need to be

underwritten to create a loan pool of certain size.

The costs of conducting due diligence of a loan pool

and the loan originator(s) are much reduced.

Therefore, consolidation in the banking sector

improves the feasibility of a secondary market for

conventional small business loans even in the

absence of uniform underwriting standardization

among small business lenders.

Scope and Methodology

The authors derived their analysis from two sources:

previous studies on the potential for a secondary

market for small business loans, small business lending, and the potential impact of credit scoring on

small business lending; and the results of interviews

with secondary market participants who had direct

experience with small business loan securitization.

The authors contacted representatives of 20 companies that participate in the conventional small business loan industry and conducted interviews with

representatives of eight companies. While the results

of these discussions are not scientifically representative of all industry participants, they do provide

insights from knowledgeable market observers who

participate in small business lending.

Ordering Information

The full text of this report and summaries of other

studies performed under contract to the U.S. Small

Business Administration’s Office of Advocacy are

available on the Internet at www.sba.gov/advo/research.

Printed copies are available for purchase from:

National Technical Information Service

5285 Port Royal Road

Springfield, VA 22161

Tel. (800) 553-6847

TDD: (703) 487-4639

www.ntis.gov

Order number: PB2003-103285

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