United States General Accounting Office

GAO Testimony

Before the Subcommittee on Government Programs

and Oversight, Small Business Committee

House of Representatives

For Release on Delivery

Expected at 2:00 p.m. EDT

on Wednesday

September 23, 1998

SMALL BUSINESS

ADMINISTRATION

Secondary Market for

Guaranteed Portions of 7(a)

Loans

Statement of Thomas J. McCool

Director, Finanical Institutions and Markets Issues

General Government Division

GAO/T-GGD-98-184

Statement 

Small Business Administration: Secondary

Market for Guaranteed Portions of 7(a)

Loans

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to discuss preliminary results of our ongoing

review of the secondary market in Small Business Administration (SBA)

7(a) loans. Under the program, SBA guarantees to repay a participating

lender a prespecified percent of the amount of the 7(a) loan in the event of

borrower default. Guaranteed and unguaranteed portions of 7(a) loans are

sold in separate secondary markets. Mr. Chairman, you requested that we

review both the guaranteed and unguaranteed secondary markets in 7(a)

loans. For the purposes of today’s hearing, I will limit my focus to the 7(a)

secondary market for the guaranteed portion. My statement has three

objectives. The first is to discuss the benefits generally provided by

secondary loan markets. The second is to describe characteristics of the

secondary market for federal government guaranteed mortgage loans. In

particular, in our review we are focusing on the market for

mortgage-backed securities (MBS) guaranteed by the Government

National Mortgage Association (Ginnie Mae). The third objective is to

describe the characteristics of the guaranteed 7(a) secondary market in

relation to those of the Ginnie Mae MBS secondary market. In conducting

our ongoing analysis on both the guaranteed and unguaranteed portions of

7(a) loans, we are paying particular attention to identifying actions that

indicate the potential to improve the efficiency of the SBA secondary

market in achieving the objectives established for it.

Secondary loan markets link borrowers and lenders in local markets to

national capital markets, thus reducing dependence on local funds

availability. The secondary market in residential mortgages is recognized

for creating this link. This secondary market has reduced regional

imbalances in the availability of loanable funds. Other benefits, which

include tapping additional sources of funds, have also helped to lower

interest rates paid by borrowers. In addition, this secondary market allows

interest rate risk inherent in holding fixed-rate loans to become diversified

among investors that might be better able to hedge against such risks than

loan originators. Our preliminary results indicate that the guaranteed 7(a)

secondary market has also linked borrowers and lenders in local markets

to national capital markets, and thus generated some of the benefits

generally created by other secondary markets. However, the guaranteed

7(a) secondary market has characteristics that limit its size in relation to

the primary 7(a) market. In particular, most 7(a) loans are variable-rate

loans with almost no interest rate risk, which reduces incentives for some

lenders to use the secondary market. In addition, 7(a) secondary market

investors, relative to MBS investors, have less information to accurately

Page 1 GAO/T-GGD-98-184
Statement 

Small Business Administration: Secondary

Market for Guaranteed Portions of 7(a)

Loans

estimate their exposure to risks associated with borrowers paying off their

loans before they are due (prepayment risks), which may limit whether or

how much they are willing to participate.

To meet the objectives of my statement, we reviewed SBA’s standard

operating procedures for its 7(a) program, rules and regulations for the

guaranteed 7(a) secondary market, and other SBA documents addressing

the role of this market. We reviewed studies on the secondary markets in

7(a) guaranteed loans and residential mortgage loans conducted by

numerous federal agencies and other parties. We obtained and analyzed

data from SBA and the Department of Housing and Urban Development

(HUD). We also interviewed representatives from SBA, HUD, Colson

Services (the program’s fiscal and transfer agent), financial industry

regulators, industry associations, and various 7(a) lenders and poolers.

Background The 7(a) loan program, SBA’s largest lending program, is intended to serve

small business borrowers who cannot otherwise obtain financing under

suitable terms and conditions from the private sector. Under the program,

SBA guarantees to repay a participating lender a prespecified percentage

of the 7(a) loan amount (generally between 75 and 80 percent) in the event

of borrower default. To obtain a 7(a) loan guarantee, a lender must

document that the prospective borrower was unable to obtain financing

under reasonable terms and conditions through normal business channels.

Borrowers participating in the program represent a broad range of small

businesses, including restaurants, consumer services, professional

services, and retail outlets.

The dollar volume of 7(a) loans that can be guaranteed under SBA’s

authority is predetermined each fiscal year by congressional

appropriations that subsidize the program. During fiscal year 1997, 7(a)

loan approvals totaled nearly $9.5 billion—the highest level of loan

approvals in the program’s history and an increase of over 20 percent from

the previous fiscal year. As of December 31, 1997, there was $21.5 billion

in total 7(a) loans outstanding.

About 8,000 lenders are approved to participate in SBA’s 7(a) program.

They range from institutions that make a few 7(a) loans annually to more

active institutions that originate hundreds annually. Most of the lenders

are insured depository institutions such as banks and thrifts. Among

nondepository lenders active in the 7(a) program are 14 Small Business

Page 2 GAO/T-GGD-98-184
Statement 

Small Business Administration: Secondary

Market for Guaranteed Portions of 7(a)

Loans

Lending Companies (SBLC) that accounted for about 19 percent of 7(a)

loans outstanding at the end of 1997.

Secondary Loan

Markets Generate

Benefits

A secondary loan market is a resale market for loans originated in the

primary market. It allows a lender to sell a loan it originates rather than

holding the loan on its balance sheet. To hold a loan on its balance sheet,

the lender would be required to obtain funding for the time period over

which the loan was outstanding. For the types of loans I am discussing,

when a lender sells a loan, it continues to service the loan by collecting

borrower principal and interest payments and taking possible corrective

actions if the borrower does not make required payments. A number of

benefits are associated with secondary markets. They provide lenders a

funding alternative to deposits, lines of credit, and other debt sources.

Secondary loan markets generally link borrowers and lenders in local

markets to national capital markets, which can provide liquidity for

lenders and thereby reduce regional imbalances in loanable funds and

possibly increase the overall availability of credit to the primary market

and lower interest rates for borrowers.

The share of loans in a primary market that are sold in a secondary market

depends on the benefits generated by the secondary market. For example,

secondary markets allow interest rate risk to be diversified among

investors with access to funding sources that help them manage such

risks. Interest rate risk is the possibility of financial loss due to changes in

market interest rates. This risk is greatest for holders of assets such as

fixed-rate loans. For example, a financial institution holding a 30-year

fixed rate mortgage on its balance sheet that it funds with short-term

liabilities can experience losses if interest rates rise. In this case, interest

earnings from the mortgage do not increase while interest costs do.

Interest rate risk is also present for variable rate loans with caps that limit

how much interest rates paid by the borrower can increase.

Adjustable-rate residential mortgages are an important example of such a

variable-rate loan product. Depository institutions that rely on short-term

deposits for funding have incentives to avoid holding fixed-rate assets on

their balance sheets. In this case, secondary markets provide a funding

source that is less likely to be disrupted in a changing interest rate

environment.

Other loan risks, such as credit risk and prepayment risk, can limit

benefits and subsequently the share of loans sold in a secondary market.

Credit risk is the possibility of financial loss resulting from borrower

Page 3 GAO/T-GGD-98-184
Statement 

Small Business Administration: Secondary

Market for Guaranteed Portions of 7(a)

Loans

defaults. When secondary market investors are exposed to credit risk,

secondary market sales can be impeded if investors lack information on

lenders, borrowers, and loan characteristics to estimate their exposure to

credit risks. Investors who purchase federally guaranteed loans and

securities are not subject to credit risk because the federal guarantees

ensure that investors will be paid on defaulted loans. However, lenders

and investors are subject to credit risk on unguaranteed loans or portions

of loans.

Prepayment risk is the risk that borrowers will pay off their loans before

maturity. For example, prepayments can lower returns to investors in

fixed-rate loans if borrowers prepay the loans when interest rates decline.

Likewise, for fixed- or variable-rate loans, prepayments can lower returns

to investors who pay a premium for a pool of loans with relatively high

interest rates. Federal guarantees do not mitigate this risk. Thus,

secondary market sales can be impeded if investors lack information on

lenders, borrowers, and loan characteristics to estimate their exposure to

prepayment risks. Analysts are able, by using various statistical

techniques, to estimate prepayment risks for large loan pools for which

information is available on the pool’s loan characteristics and historic

prepayment rates on statistical samples of similar loans. In contrast, such

estimates are less reliable for securities backed by loan pools composed of

a relatively small number of loans. The size of the pool is important

because loans with cash flows that represent statistical outliers are less

likely to cause the cash flow from a large pool to differ from those of other

representative statistical samples of similar loans.

The Ginnie Mae

Guaranteed MBS

Market Is Large

Ginnie Mae is a government corporation that is part of the Department of

Housing and Urban Development. Ginnie Mae participating lenders

originate mortgages insured by the Federal Housing Administration (FHA)

and the Department of Veterans Affairs (VA) for resale in the secondary

market. These lenders issue mortgage-backed securities backed by cash

flows from these mortgages. For a fee of 6 basis points1

, Ginnie Mae

guarantees timely payment of principal and interest on these securities.

Currently, over $500 billion in MBS backed by Ginnie Mae is outstanding.

Most mortgages backing Ginnie Mae MBS are FHA insured mortgages.

Most Ginnie Mae lenders are mortgage bankers, a group which includes

independent firms without deposit bases as well as subsidiaries of

depository institutions. This secondary market allows mortgage bankers to

1

A basis point is one one-hundredth of a percentage point.

Page 4 GAO/T-GGD-98-184
Statement 

Small Business Administration: Secondary

Market for Guaranteed Portions of 7(a)

Loans

compete in the primary market for loan originations even though they do

not have a deposit base to finance the mortgages on their balance sheets.

Due to competitive forces in the primary market and as a result of

increased access to additional sources of funds for lenders, this secondary

market has contributed to lower interest rates paid by borrowers on

federally insured mortgages. Over 90 percent of single-family FHA

mortgages have been sold in the Ginnie Mae MBS secondary market.

Over 70 percent of FHA insured mortgages are fixed-rate mortgages. These

mortgages have greater interest rate risk than adjustable-rate mortgages.

In addition, for adjustable-rate mortgages, FHA limits the degree to which

interest rates paid by the borrower can increase to a maximum of

1 percentage point annually and 5 percentage points over the life of the

mortgage loan. Therefore, Ginnie Mae guaranteed MBS backed by

FHA-insured adjustable-rate mortgages also entail interest rate risk for

investors. As I discussed earlier, the presence of interest rate risk in a

primary market increases the attractiveness of the secondary market to

loan originators.

An investor in a Ginnie Mae MBS is to receive an offering statement that

discloses the issuer of the MBS, which is normally the lender. Other

information to be disclosed includes the value of loans in the pool and

characteristics of the loans, such as whether they are 30-year fixed-rate or

adjustable rate. The minimum pool size is eight loans, but most pools are

much larger. For a fixed-rate MBS pool, interest rates paid by borrowers in

the pool must be within one percentage point of each other. For MBS

backed by adjustable-rate mortgage pools, the index used to adjust the

interest rate paid by the borrower must be specified. Therefore, in

estimating prepayment risk, the investor is helped by being able to analyze

a relatively large and homogeneous loan pool issued by a particular lender.

Investors in Ginnie Mae MBS include mutual funds, pension funds,

insurance companies, and individuals.

Characteristics of the

Guaranteed 7(a)

Secondary Market

Differ From Those of

the Ginnie Mae MBS

Market

In the guaranteed 7(a) secondary market, investors purchase certificates

backed by cash flows from pools of the guaranteed portions of 7(a) loans.

The secondary market for 7(a) pool certificates started in 1984. This

market provides lenders a potential funding source to originate more small

business loans. As I stated earlier, participating lenders include depository

and nondepository financial institutions. Nondepository institutions

benefit relatively more from this secondary market, because they do not

have a deposit base to help them finance 7(a) loans on their balance

Page 5 GAO/T-GGD-98-184
Statement 

Small Business Administration: Secondary

Market for Guaranteed Portions of 7(a)

Loans

sheets. Particularly active among nondepository lenders are 12 SBLCs that

accounted for about 19 percent of 7(a) loans outstanding at the end of

1997.

In this market, SBA 7(a) lenders sell their loans to pool assemblers who

form pools by combining the loans of a number of lenders and then sell

certificates backed by these pools. Colson Services, SBA’s fiscal and

transfer agent (FTA), monitors and handles the paperwork and data

management system for all 7(a) guaranteed portions sold on the secondary

market. Colson also serves as a central registry for all sales and resales of

these portions. The firm receives payment from lenders for its secondary

market services equal to 12 1/2 basis points of the value of certificates for

guaranteed portions under Colson’s management. In 1997, SBA 7(a)

secondary market sales of pooled guaranteed portions was approximately

$2.6 billion.

In contrast to Ginnie Mae guaranteed MBS that are backed by cash flows

from whole loans, 7(a) loans are divided into separate guaranteed and

unguaranteed portions for secondary market sales. SBA reported that in

1997 over 12,000 7(a) guaranteed portions were sold on the secondary

market, about 40 percent of all 7(a) loans approved that year. In recent

years, anywhere from a third to almost half of the guaranteed portions of

loans originated have been sold on the secondary market. This is in

contrast to Ginnie Mae guaranteed MBS, which represent over 90 percent

of outstanding federally insured residential mortgage loans.

The guaranteed 7(a) secondary market is smaller and less active, and

provides lenders with fewer incentives to sell loans than the federally

insured residential mortgage market. At the end of 1997, about $10 billion

in guaranteed portions of 7(a) loans were outstanding, while Ginnie Mae

guaranteed MBS had over $500 billion outstanding. The 7(a) market does

not benefit from the incentive for lenders to sell on the secondary market

to mitigate interest rate risk, because the 7(a) program consists mainly of

variable-rate loans without interest rate caps. Almost 90 percent of 7(a)

loans made in 1997 were variable- rate loans without interest rate caps.

Because interest rates are adjusted at least quarterly to reflect market

rates, these loans entail almost no interest rate risk. In addition, SBA 7(a)

loans can consist of loans backed by a variety of items, such as real estate,

production inventory, or equipment, and 7(a) loans finance a broad range

of businesses. Residential mortgages are all backed by residential

property.

Page 6 GAO/T-GGD-98-184
Statement 

Small Business Administration: Secondary

Market for Guaranteed Portions of 7(a)

Loans

Because of the heterogeneous nature of 7(a) loans, analysts are less able

to accurately estimate prepayment risks. Some participants in the

secondary market for 7(a) guaranteed portions expressed concern that

information useful to investors in analyzing prepayment risk is not

available when pool certificates are resold, limiting investors’ ability to

resell in this market. SBA is concerned that providing such information to

investors could reduce benefits to some 7(a) borrowers by potentially

allowing investors to identify individual borrowers and groups of

borrowers. According to SBA, all investors in 7(a) guaranteed pool

certificates are institutional investors, such as pension funds, insurance

companies, and mutual funds.

In summary, secondary market volume for both the guaranteed portions of

7(a) loans and federally insured residential mortgage loans is a market

outcome that depends on the relative benefits provided by the respective

secondary markets compared to other methods of finance.

For the most part, SBA has few if any means to change factors that,

through market forces, limit the relative size of the secondary market. For

example, heterogeneity in loan characteristics, which results from the 7(a)

program’s intention to serve a broad range of small businesses, limits the

ability of investors to estimate prepayment risk.

As we continue our work, we will consider SBA actions that indicate the

potential to improve the efficiency of the SBA 7(a) secondary market in

achieving the objectives established for it.

Mr. Chairman, this concludes my prepared statement. I will be happy to

respond to any questions you or other Members of the Subcommittee may

have.

(233583) Page 7 GAO/T-GGD-98-184
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