A Word from Arne
Our last newsletter detailed the current situation regarding the government budget, and the reported shortfall (also known as a positive subsidy) of $99 million in the funding of the SBA 7(a) program. The SBA is required to operate at a zero subsidy, and the federal Office of Management and Budget (OMB) uses a complex formula to calculate the financial condition of the popular 7(a) program. It is widely understood that the OMB calculation method is flawed and does not reflect the actual operations of the SBA 7(a) program. Furthermore, the SBA over-charges its borrowers through fee assessments. Surplus fees have amounted to approximately $3 billion since 2010. Because these funds are returned to the U.S. Treasury, in effect they simply amount to a hidden tax on users of the SBA 7(a) program.
The Impact of the OMB Subsidy Calculation
While we believe the OMB’s subsidy calculation is effective and must be corrected, at the moment we also face a related but more immediate concern: The SBA 7(a) program stands to be shut down unless Congress either appropriates funds to cover the phantom subsidy shortfall or enacts a Continuing Resolution to fund the Administration for a limited amount of time. We at H&M are working diligently to help advance both short-term and permanent solutions to this problem.
Protecting the SBA Loan Guaranty
As the leading Lender Service Provider in our industry, we are constantly seeking ways to improve our own delivery methods. However, we continue to encounter a troublesome issue, which I want to share with you. So that lenders can make much-needed 7(a) loan capital available to creditworthy borrowers, lenders can take advantage of a credit enhancement provided by the SBA—a Loan Guaranty that pays up to 85 percent of the loan’s principal and is backed by the full faith and credit of the U.S. government.
The Guaranty is critical to 7(a) lenders because it proves them with a fallback position in the event a borrower defaults on the loan. But before requesting a Guaranty on any SBA 7(a) loan, lenders must prepare and comply with a complete Credit Memo, as required by SBA Standard Operating Procedures. The lender’s Credit Memo demonstrates reasonable assurance of repayment and must include at a minimum: brief description of the history of the business; length of time current management has led business and depth of management experience in current or a related industry; owner/guarantor analysis (via personal financial statements); confirmed collection, verification and reconciliation of business’s tax returns. In order to avoid early defaults and Guaranty denials, lenders should write Credit Memos under the assumption that they will be read by the SBA Inspector General.
Our company was founded with the purpose of helping community lenders realize all of the benefits of offering SBA and USDA loans to creditworthy businesses in their areas. If you have any questions about government-backed loans, or would like to clarify any information, please feel free to contact us. We serve as the out-of -house SBA/USDA loan department for many institutions and we’re proud to be recognized as a preferred provider by the Independent Community Bankers of America (ICBA). We welcome any opportunity to help you.
A guide to finding liquidity among your holdings
by Jim Reber, President and CEO, ICBA Securities
Quick: What are the most saleable assets on your community bank’s balance sheet? If you get this wrong, you need to be running a “not-for-profit depository financial institution.”
Bonds, of course. Most people I talk to consider the liquidity feature a close second (to safety) in importance when contemplating a purchase. That feature has come into play for thousands of community banks in the last several years, as loan demand has outstripped deposit growth. Between December 2013 and December 2018, investments as a percent of assets dropped from 23% to 18% for the community bank industry as a whole. While most of the decline was simply maturing bond proceeds being reallocated into loans, some portion was outright securities sales to fund new credits.
Assist: Federal Reserve
You may also have noticed that your bonds’ prices have risen in 2019. Since rates peaked last November, there has been a strong market rally across the entire yield curve, particularly beyond two years. For example, if you had purchased the new five-year Treasury note last November, you would now have a nearly five-point gain in that bond. Yields in that sector are down around 125 basis points in about seven months.
That has essentially wiped out unrealized losses in community banks’ bond portfolios. As of the end of June, the average portfolio was worth slightly more than the collective book prices of the bonds. What that means in practice is that you probably own some bonds at higher prices than they’re currently worth, and others at lower prices. And this is exactly what you should hope for.
If a community bank owns some winners and some losers, and it decides it needs to sell, it can manage the impact on current year earnings very easily. As 2019 progresses, it’s clear that industry earnings will be quite good, so it is entirely possible that a bank may choose to realize some losses on sales of bonds now, and push that income (and tax liability) into future years.
Priced to sell
Assuming for the moment that a community bank is ambivalent about booking any gains or losses, and is instead more focused on the creation of a liquidity pad, there is a basic rule of portfolio management that needs to be applied to achieve maximum benefit. This is the concept of the “take-out yield.” Take-out yield has several other nicknames like market yield or give-up yield, and what it quantifies is the yield that a purchaser of your bond would get, if you were to sell that bond today.
The lower the take-out yield, the more efficiently you have sold your bond. Economically, the seller will have to re-employ the proceeds at a return higher than the take-out yield for the sale/reinvestment to make sense. So a wise portfolio manager will resist the temptation to cash in gains, unless the sale item results in a low take-out yield. Your broker should readily identify the take-out yield on any security that you’re thinking about selling at the same time you receive a bid.
Keep these in mind
There are a couple of other variables that could impact if, or what, your community bank might sell. One is that you likely can’t sell a bond that was designated Held to Maturity on purchase date. That alone is a good reason to classify 100% of your bonds as Available for Sale.
Another widely under-reported fact of the bond market is that liquidity will dry up as we approach a quarter- or year-end. How much this affects prices is difficult to quantify, but I would recommend not bidding anything within two weeks of the end of a reporting period.
Also, you likely have other liquid assets on your balance sheet, besides your investments. There is a robust secondary market for most performing loans, beyond conforming residential mortgages. Government-guaranteed sectors such as SBA 7(a) and USDA loans can be efficiently sold. And even non-guaranteed loans can fetch attractive prices, especially in the current yield environment.
A final thought: usually, yield spreads widen as interest rates fall. They have not yet widened out noticeably from the peak in rates late last year, at least on many sectors that are popular with community banks. This includes callable agencies, munis and straight pass-through mortgage-backed securities. All of which makes the mid-2019 bond market an attractive time to consider targeted sales.
Bid thee well!
Jim Reber is president and CEO of ICBA Securities and can be reached at 800-422-6442 or email@example.com.
Vining Sparks, ICBA Securities’ exclusively endorsed broker, has an interactive website with portfolio management tools. Included is a private portal, which can help identify securities that may be attractive sale candidates. For access to the website, contact your Vining Sparks sales rep or visit www.viningsparks.com.
Extending Maturity Dates
Lenders sometimes encounter situations that call for extending the maturity dates of SBA term loans and lines of credit. Extensions can be accomplished, but care must be taken to follow the established requirements. The maturities of unsold SBA credit facilities (both term loans and lines of credit) may be extended under the lenders’ unilateral authority BEFORE the facilities mature. After maturity, the extension process becomes more complicated, and requires approval granted by the SBA. It’s always a good practice to be aware of maturing SBA credit facilities.
SBA Loan Authorizations require multi-disbursement loans to be fully disbursed on time. Small amounts of undisbursed funds should be advanced per Authorization rules. If any approved loan proceeds are not needed, lenders must submit a servicing request to reduce loan and guaranty amounts.