“How about…you know…. a little something for the effort…. you know ….”
Groundskeeper Carl Spackler to the Dalai Lama– Caddyshack

Thinking about SBA lending and bank relationships makes me think of Carl, the groundskeeper in Caddyshack. It does take extra effort to be an SBA lender. The economics of it are a case of strange bedfellows – Main Street small businesses and the capital markets.

We have highlighted the government guarantee in SBA lending as a credit enhancement, enabling extended terms and under-collateralized requests. In my opinion, the role the guarantee plays in revenue generation is likely the most compelling case of all for SBA lenders.

Loan Sale Premiums

Most SBA loans come with a 75% government guarantee. Some more, some less, but for now we will just use 75% as the standard. That portion of the loan immediately assumes the full strength and credit of the U.S. government, which mean that it has a ready market for resale to bond investors. SBA lenders have the option of maintaining the loan on their balance sheet or selling the guaranteed portion in the secondary market and retaining the unguaranteed portion on their balance sheet. A sale will typically generate a loan sale premium (fee income) for the bank, while the kept portion will produce interest income.

Now, if you are a bond investor with a book of government obligations, you would be looking today at a 10-year T-bill yield of .65%. A 10-year SBA loan can bear a rate of up to Prime + 2.75%. In today’s rate environment, that would equate to 6%. I do not want to get deep into what bond investors do, and how they do it, but it is fairly intuitive that if you had two obligations both backed by the full strength and credit of the US government, and one had a coupon of .65% and the other had a coupon of 6.00%, you would be highly desirous of the second option. In fact, you could pay a premium for that yield stream and still beat the .65% coupon on the 10- year T-bill.

Let’s look at a quick SBA lending example, again just for illustration. I assure you it can be much more complicated than this. The illustration is a fair depiction of what happens, and for most rate environments a solid example of income opportunity. Your bank extends a $1,000,000 SBA loan to you on a ten-year term at full pricing (6% as of today). The bank sells $750,000 of the loan to a bond investor. The bond investor pays a 10% premium to the bank for the rights to the enhanced yield stream. The bank collects $75,000 in fee income from the investor, reduces the loan on its balance sheet to $250,000, and continues to collect 6% annually on the kept portion – roughly $15,000 in year one but not exactly because of amortization. The fee income from the loan is 5x the interest stream in the first year. That’s “a little something for the effort”! Keep in mind, the lower the rate, the less the loan sale premium because the differential to the 10-year T-bill is reduced. Most lenders strive to get full pricing for the effort.

Who would have thought that Main Street could wriggle its way into some of the most well-recognized bond shops in the country?

Liquidity

A more subtle nuance to the bank’s income stream is that the liquidity mechanism of the secondary market allows it to expand its balance sheet capacity. In the scenario above, the bank has accommodated a $1,000,000 need of its client, but only taken up $250,000 of balance sheet space, so conceivably it could go do that three more times before it had the same balance sheet impact. The liquidity feature alone is very compelling for smaller community banks with limited balance sheet flexibility.

PPP Friction

As PPP lurched onto the coronavirus scene, both issues presented themselves as potential friction points. The “extra effort” would be on a scale almost unimaginable pre-pandemic. As of today, with all funds allocated, the SBA took more applications in 14 days than it did in the prior ten years combined. Most banks I know had all hands on deck, inputting applications at all hours to meet the demand. Yet, there was no loan sale premium opportunity, with just a two-year term if the balance were not forgiven and a coupon of 1%. I suspect banks gladly overlooked incremental income for the risk mitigation the program offered. Losing 100% of a loan balance to default is a sight heftier than the annual interest rate. The number of banks who offered the program to existing borrowers only might support that – no conspiracy theory intended.

In my opinion, the liquidity issue was much more problematic. It was a true “pig in a python” loan volume proposition, with smaller community banks most affected and therefore most skittish in the first couple of days of the program. According to news reports, it was Money Center banks who dominated application volume in the first few days of the application process. Ultimately, The Federal Reserve and the Treasury Department established a credit facility to provide term financing backed by PPP loans, similar to the way in which government works with mortgage agencies like Fannie Mae and Freddie Mac. The commitment moved many smaller lenders off the fence and effectively exhausted the $350 billion total commitment in two weeks’ time. There is still pent-up demand for the program among Small Business owners.

Momentum Lesson

The PPP SBA lending experience has evolved over the past week and a half, as this blog series has progressed. The momentum lesson I started with is still valid – high energy is great, but energy needs a vector to build momentum. The friction points in the ongoing relationship between SBA and approved lenders were clear factors in the bumpy start to the program. Better communication and trust-building would have had more people pushing collectively right out of the gate. Now, I reflect on another important momentum lesson – a vector always has direction AND distance. Turns out, $350 billion is just not much when you have 30 million small businesses in the US, and the likes of hedge funds are dipping into it. April 16, 2020. Out of money. PPP stopped in its tracks by shortsighted bureaucrats who apparently cannot access payroll data in advance to come up with the right number. Hopefully next round, everyone will be pushing hard, in unison, and on a runway that is long enough for everyone to get airborne.