1 Graduate School of Colorado SBA lending Presentation
2 SBA lending course summary The course will provide an overview and comparison of SBA 7a, SBA 504 and USDA Business & Industry (B&I) loan programs. SBA loan guaranty sales and yield. How SBA lending can improve a bank, from a CAMELS perspective. What is required to have a successful SBA lending operation, including the SBA loan process and cost structure.
3 SBA 7a Lending
4 SBA 7(a) Guaranty Loan Program Total guaranteed amounts may not exceed $3,750,000 Included outstanding SBA loans to borrower and its affiliated businesses Total loan amount may not exceed $5,000,000 Rates typically up to WSJ Prime %, Fixed and variable rates allowed. $150,000 or less = 85% Over $150,000 = 75% SBA Express = 50% SBA Express loan amount may not exceed $350,000
5 SBA 7a Maximum Loan Terms The loan term is based on the type of asset being financed. So the term of the loan is driven by use of proceeds and not by collateral Based on Asset Type Real Estate 25 years Equipment 10 years Working Capital 7-10 years Mixed loan use Blended term Or Largest asset
6 SBA 7a Charging of Fees Prohibited Fees (may not to be charged to borrower) Commitment, broker, referral fees Contingency fees (fees paid only if loan is approved Application fee Points and add-on interest Sharing of secondary market premiums Allowable Fees (may be charged to the borrower) Packaging fees (to prepare the loan application) Extraordinary servicing fees Direct expenses, such as legal fees Late payment fee (part of Note language)
7 SBA 7a Eligibility The SBA guaranty MUST be necessary Credit elsewhere rule The principals must not have excess liquid assets Personal resources rule The business must meet the SBA s size standards and type of business restrictions.
8 SBA 7a Size Standards Two approaches to determining size standard eligibility SBA 7(a) NAICS code driven Retail: typically may not exceed $7 million in gross sales over last 3 years Wholesale: typically may not have more than 100 employees Manufacturing: typically may not have more than 500 employees Alternative Size Standard Tangible N/W may not exceed $15 million Average net income not to exceed $5 million Must include financial information for both business applicant AND its affiliate businesses
9 SBA 7a, ineligible Business Types Ineligible businesses: Non-profits Financial businesses Passive businesses Life insurance companies Pyramid sales distribution plans Legal gambling businesses (more than 1/3 of annual revenue) Business limiting access (private clubs) Government owned businesses Businesses engaged in teaching religious beliefs Sexual oriented businesses Businesses engaged in political or lobbying activities Speculative businesses
10 SBA 7a Eligible Business Types Some ELIGIBILE Business Types: Franchises As long as the franchisor does not have power of control over the franchisee (your borrower) Businesses owned by non-u.s. citizens Certain documentation required Primary owner must be a legal permanent resident or US citizen Eligible Passive Company (EPC) All parties must be financially obligated Operating company (OC) and 20% or more owners of OC and EPC No return on investment (lease payment = loan payment)
11 SBA 7a Eligible Use of loan Proceeds Purchase real estate and improvements Acquire equipment and fixtures Purchase inventory Acquire existing business Provide working capital Refinance existing debt
12 SBA 7a Restricted Loan Proceeds Refinancing: The lender can refinance loans on its books and convert them to SBA loans Long term debt existing payment must be decreased by at least 10% The loan being refinanced must be on unreasonable terms Short term debt considered unreasonable (credit cards, LOCs, demand notes, balloon notes) Business Acquisitions: Entire business vs. Entire interest The seller may not remain involved in the business after loan funding A business valuation is required, If intangible assets exceed $250,000 or the transaction is between close family members, the valuation must be performed by a third party
13 SBA 7a Restricted Loan Proceeds (cont.) Purchase of Real Estate: Space occupancy restriction Existing building: business applicant must occupy at least 51% New construction: business applicant must occupy 80%, eventually and 60% immediately The Associate Rule: Loans proceeds may never be funded to an associate of the business Associate = officer, director, stockholder, key employee
14 SBA 7a Credit Issues Guarantors: 20% or more owners must provide full unlimited personal guaranty Other owners of less than 20% may provide a full or limited personal guaranty Collateral: SBA requires the 7(a) loan be fully secured with all available assets Fully secured means that the liquidation value must equal or exceed loan amount Equity: Cash, Debt, Assets, Standby Debt Character of Principals: Form 912 required for 20% or more owners and key people The 912 is effectively a criminal background check
15 SBA 504 Lending
16 504 Loan Structure Borrower 10% SBA 40% (junior lien position on fixed assets) Participating lender 50% (senior lien position on fixed assets) Borrower may be required to provide up to 20% Start up business Single purpose real estate collateral Generally the project assets being financed are used as collateral
17 SBA 504 Certified Development Companies - CDCs CDC is a nonprofit corporation that promotes economic development within its community through 504 loans CDCs are regulated by the SBA CDCs work with the SBA and participating lenders to provide financing to small businesses Over 260 CDCs nationwide Serve specific geographic areas, typically the state where the CDC is located
18 504 Loan Funds May be Used Purchase existing buildings Purchase of land and land improvements, including grading, street improvements, utilities, parking lots and landscaping Construction of new facilities or modernizing, renovating or converting existing facilities Purchase of long-term machinery Refinancing of debt in connection with an expansion of the business through new or renovated facilities or equipment Can not be used for working capital or inventory
19 504 Loan Eligibility Business must be operated for profit Business must not have tangible net worth of more than $15 million Business must have average net income for the preceding two years of less than $5 million Business engaged in nonprofit, passive or speculative activities do not qualify
20 Other 504 Specifics Maximum SBA debenture is $5 million Job creation of 1 job per every $65,000 guaranteed by SBA Small manufacturers 1 job per every $100,000 guaranteed by SBA As an alternative to job creation or retention business may qualify if it meets a community development or public policy goal
21 504 Secondary Market Zions First National Bank started purchasing the 504 loans made by participating lenders in the early 1990s. They were soon followed by Bank of the West, Lehman Brothers, GE Capital, and others The great recession eliminated all of the secondary market buyers except for Zions In 2010, Morgan Stanley began purchasing the 504 first lien loans and One West Bank has started purchasing 504 loans in California
22 USDA Business & Industry (B&I) Lending
23 USDA B&I Loan Limits & Locations USDA B&I loans have no minimum loan amount $10 Million maximum without Administrator exception Up to $25 Million to any one borrower Up to $40 Million for rural cooperative organizations Rural Area Anywhere except within the boundaries of a city or town with more than 50,000 inhabitants or the urbanized area of that city or town.
24 USDA B&I Typical Loan Purposes Real estate purchase and improvements Machinery and equipment purchase Working capital Debt refinancing and business acquisitions under certain conditions
25 Fees and Percentage of Guarantee Fees Initial Guarantee Fee 2% in most cases Annual Renewal Fee 0.25% subject to change Percent of Guarantee Maximums Greater than $10 MM 60% $5MM - $10MM 70% $5MM 80% Under special circumstances, a higher guarantee percentage is awarded on larger loans (i.e.: $10MM loan with 90% guarantee)
26 USDA B&I Loan Structure Negotiated by the lender and borrower Rates can be Fixed/Variable/Combination, but cannot adjust more often than quarterly Origination fees and prepayment penalties are permitted No balloon payments
27 USDA B&I Maximum Loan Terms Real estate 30 years Machinery and equipment the lesser of 15 years or useful life Working capital 7 years
28 USDA B&I Collateral Requirements Must be sound and sufficient to protect interests of the lender and Agency (normally discounted value will be at least equal to the loan amount) Must be appropriately discounted Cannot secure unguaranteed portion with additional collateral
29 USDA B&I Conditional Commitment Establishes Agency loan requirements and conditions All conditions must be met before the Loan Note Guarantee is issued
30 USDA B&I Secondary Market There is a very active secondary market for the purchase of USDA B&I Guaranteed loans, however, the loans are not pooled Premiums are fairly consistent with those paid on SBA 7a guarantees Lender can set and receive the prepayment penalty on an B&I loans Lender can set the level of servicing income on a B&I loan to be less then 1.0%.
31 SBA 7a Guaranty Loan Sales
32 SBA 7a Loan guaranty sale One of the most interesting aspects of SBA lending is that the guaranty on the loan can be sold in an active secondary market and earn a premium Currently, if a bank makes a $1,000,000 SBA loan at Prime % for 25 years, they can sell the 75% guaranteed portion of that loan and generate a premium of approximately 19.0%. However, the SBA requires the bank to split any portion of the premium over 10.0% with the SBA. So the net premium in this example would be 14.5 In addition, when the investor buys the guaranty, they don t get the 6.0% note rate, they actually get a 5.0% rate, and the 1.0% difference is allocated to the bank to cover the cost of servicing.
33 Sample bid matrix par Par (All Variable Rate premium quotes are based on 1.00 servicing)
34 How can SBA 7a lending positively impact a bank s CAMELS rating
35 CAMELS Earnings Because the SBA guarantees 75% to 85% of each loan, lending institutions can use this program as a tool to mitigate risk in their loan portfolio. The guaranteed portion of each loan can be immediately sold on the secondary market. Let s look at the math in this sample loan: Loan Amount $1,000,000 Guaranteed Portion $ 750,000 Net gain on sale of the guaranteed portion $ 108,750 (14.5% premium) The bank retained portion $ 250,000 (60% ongoing interest income) This is an example of a 25-year commercial real estate loan priced at Prime %, or 6.0%.
36 Capital SBA loans are always accretive to capital if the guarantees are sold, which in turn will improve the bank s Risk-Based and Leverage capital ratios. If a bank s growth is limited due to capital constraints, SBA lending is a potential solution because it enables the bank to continue lending and generating profits. This is especially beneficial when you use an SBA loans to refinance existing conventional loans.
37 SBA loans are always accretive to capital. A key advantage to making SBA loans is that if the guaranty is sold, the loans increase capital instead of depleting capital. Here s an example of how a conventional loan compares to an SBA loan: Conventional loan Loan Amount $1,000,000 Risk Based Capital Required $100,000 SBA loan Loan Amount $1,000,000 Guaranteed Portion $750,000 (Net Gain on sale of guaranty $108,750) Unguaranteed portion $250,000 Risk Based Capital Required $25,000 (Lender increases its capital by $83,750)
38 SBA loan Example Assume that ABC Bank has a Machine Shop commercial loan customer that has a real estate loans and an equipment loan with the following original terms: 1. Commercial real estate loan was for 6.0% interest with 5 year call and 25 year amortization, current payment is $7, Equipment loan was for $600,000 at 6.0% for 5 years, current payment is $11,600. The combined payment is $19, Commercial R/E appraised for $2,000, Equipment appraised for $500,000.
39 SBA loan Example The borrower is requesting a $100,000 working capital loan to help with their cash needs, but the bank cannot provide the loan on a conventional basis, because the business s cash flow doesn t support it Revenues $2,000,000 $1,800,000 $2,200,000 Cash Flow $250,000 $200,000 $260,000 Current DSC 1.08:1 0.86:1 1.12:1
40 SBA loan Example So the bank opts to restructure the borrowers debt and provide the working capital with and SBA loans, as follows: Refinance the Commercial Real Estate loan $1,000,000 Refinancing the Equipment loan $ 500,000 Provide working capital $ 100,000 Total Request $1,600,000 New SBA loan of $1,600,000 for 25 years at 6.0%, with a payment of $10,309.
41 SBA loan Example Revenues $2,000,000 $1,800,000 $2,200,000 Cash Flow $250,000 $200,000 $260,000 Current DSC 1.08:1 0.86:1 1.12:1 DSC with SBA loan 2.02:1 1.62:1 2.10:1
42 SBA loan Example Benefits to the bank: 1. Improves asset quality, on a credit that might be considered Special Mention, to a pass credit by significantly improving the borrowers cash flow. 2. The bank s asset quality is improved, since their exposure is reduced from $1,500,000 to $400,000 ($1.6M X 25%). 3. The bank s capital position is improved, since the Loan Loss Provision is reduced from $30,000 (2.0% X $1.5M) to $8,000 (2.0% X $400,000). 4. If the bank sells the guaranteed portion of the loan, earnings are enhanced since they will make a $174,000 premium ($1,200,000 X 14.5%) on the sale. 5. The Bank s Capital is improved, since the Risk Based Capital requirement for the original $1,500,000 in loans would have been 10% or $150k and the new loan of $400,000 has a capital requirement of $40k, a $110k savings. 6. The total capital improvement from the SBA refinance would be $22K savings to the ALLL, $174k gain on sale and a $110k savings of capital. The total capital improvement will be $306k.
43 Servicing Income When the guaranteed portion of an SBA loan is sold, the investor buys the guaranty at a rate that is 1.0% less than the note rate. For example if you have a $1,000,000 SBA loan at an interest rate of 6.0% and the bank sells the $750,000 guaranteed piece, they would sell it at a yield to the investor of 5.0%. This means that the bank will earn 6.0% on the $250,000 portion that they retained and 1.0% on the $750,000 or $7,500 per year, not accounting for amortization of the loan. If you compare that $7,500 per year in servicing income to the $250,000 that the bank retains on its books, you can see that it represents an additional 3.0% yield on the retained portion. That 3.0% of servicing, plus the note rate of 6.0%, shows that the bank s gross yield on the retained portion of the loan is now 9.0%.
44 Liquidity Regulators recognize the strong secondary market for SBA guarantees and will allow them to be counted as part of your bank s liquidity structure. This high-yielding substitute for other securities can also be sold when extraordinary expenses occur.
45 Yield & Liquidity Benefits Yield and Liquidity benefits when an SBA loan is held. The following shows a bank s net yield after all costs have been considered. Loan Amount $1,000,000 Interest Rate 6.0% SBA/Colson fee (0.55% of the guaranteed portion) Loan acquisition costs (2.0% amortized over 6 years) Underwriting & processing costs (2.0% amortized over 6 years) Servicing costs 0.50 (Estimated annual cost) Net yield to the bank
46 Yield & Liquidity Benefits (cont.) The regulators consider SBA guarantees to be treasury equivalents and recognize them as a component of a banks liquidity. Most banks keep at least 15% of their assets liquid and generally keep them in low yielding but safe investments, such as fed funds. Lets assume that you have a $200 million asset size bank, that earns a 1.0% return on their assets, or $2.0 million per year. They have $30 million in liquidity, which at the current fed funds rate earns the bank $75,000 per year. Now lets say that the bank generates $10.0 million in SBA guarantees and retains them as a portion of their liquidity. Now they are earning $50k on the $20.0 million in fed funds and $442,150 in net yield from the $10 million in SBA guarantees, for a total of $492,150 or $417,150 more than what they were previously earning.
47 Assets The SBA loan guarantee can be used to refinance existing loans in your loan portfolio to mitigate risk or to help retain clients who are close to the bank s legal lending limits. Using SBA lending to refinance existing bank loans can be helpful in reducing real estate concentrations, since properties like hotels, mini storage facilities and care facilities are included as investment properties by regulators. If a bank has these types of properties on their books, they can often refinance the loan and sell the guaranteed portion to reduce a concentration and free up capital.
48 Assets (cont.) Using the SBA guaranty to make loans that fall into an investment property category is a good way of managing portfolio concentration growth. Conventional loan portfolio $1,000,000 Risk Based Capital Requirement $ 100,000 (10.0%) ALLL Provision $ 20,000 (Assumes a 2.0% ALLL) Refinance existing loan to SBA $1,000,000 Guaranteed portion to be sold $ 750,000 (RBC 0.0%) Gain on sale of guarantee $ 90,000 (at current 12.0% Premium) Reduction in ALLL on sold portion $ 15,000 (Assuming 2.0% ALLL) Unguaranteed portion $ 250,000 (10.0% RBC) Risk based capital requirement $ 25,000 Overall capital improvement $ 180,000 The capital improvement of $180,000 comes from the $90,000 loan premium, the $75,000 of capital relief from reducing the loan by $750,000, a $15,000 reduction of the ALLL.
49 Mitigating risks related to SBA lending. Credit Risk The financial institution determines whether it is comfortable with the credit risk, verifies that the financing is eligible for SBA and structures the loan per SBA guidelines. Guarantee Risk The best way to reduce this risk is to submit the loan to SBA for their approval. Some lenders have Preferred Lending status, which allows them to approve loans on their own this increases the risk that SBA could come back and deny the guaranty in the event of default. Documentation Risk According to SBA, documentation errors are one of the top three reasons for guaranty denial. Servicing Risk Every time someone touches an SBA file, they potentially put the guarantee at risk. The bank must have experienced staff to properly maintain the loan portfolio and enable the institution to stay in compliance.
50 Case Study Improvement to a bank s capital structure by refinancing SBA loans Assume that you have a $100 million asset size bank, with $7.0 million in capital and a 7.0% leverage capital ratio. The bank has $8,000,000 of commercial loans that they want to refinance into SBA loans and then sell the guaranteed portions. Assume a guaranty percentage of 75% and calculate as a pretax number. Existing ALLL against the portfolio is 2.0% Assuming that the refinanced SBA loans are priced at P+2.25% and they are all 10 year loans.
51 Case Study (cont.) 1. What is the premium % yield on the sale of the loans? 2. What is the dollar gain on the sale? 3. What is the reduction in assets? 4. What is the reduction in ALLL? 5. What is the increase in capital? 6. What is the new leverage ratio?
52 The SBA loan process & cost structure
53 Sourcing SBA Loans Experienced SBA business development officers than can generate $10 million or more in closed SBA loans, will generally receive a salary of around $80k along with a commission plan that will pay them another $70k if they reach their $10 million target. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
54 Sourcing SBA Loans (cont.) That salary and commission totals $150k, for $10 million on production or 1.5%. Many banks will consider SBA loans referred by a broker, which will add an additional 1.0% or more to your loan sourcing cost structure. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
55 Sourcing SBA Loan (cont.) Obviously, using your existing lending staff to generate SBA loans seems to be a more cost effective approach, since you avoid the additional salary and large commissions. However, if you chose this route, you must make sure to provide training to your staff to aid them in identifying SBA loan prospects. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
56 Sourcing SBA Loans (cont.) With either structure, the bank must also make sure that your credit department has defined what types of SBA loans that they will consider. However, in order to justify hiring SBA underwriters and processing personnel, you have to make sure that you generate loans. In order to enhance your likelihood for success, you should provide your commercial lenders with SBA training, loan production goals and a commission plan, so they will be motivated to source SBA loans. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
57 Underwriting & Processing It is absolutely critical to hire the very best people that you can find to underwrite and process your SBA requests. In terms of experience, you will want to find staff that has underwritten or processed at least 50 loans in their career. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
58 Underwriting & Processing (cont.) Requiring a higher level of experience means that you will likely have to pay salaries on the higher side of the market to get this caliber of SBA staff. The salary costs for a strong underwriter and processor are likely to be $150k combined. When you add in benefits, office space, equipment, software, ongoing training, etc., your cost for this two person back shop will be around $200k. If the department generates $10 million in production, then your back shop cost is an acceptable 2.0%. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
59 Servicing Once the loan is closed, the bank will still need to treat their SBA portfolio differently from a conventional commercial term loan. The bank will have to make sure that their core system will accommodate SBA loans and accrue interest correctly. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
60 Servicing (cont.) The bank will need to prepare a monthly 1502 report to SBA s Fiscal Transfer Agent, Colson and be able to deal with SBA s servicing requirements related to modifications or changes to the loan. It is critical that the bank have someone in there note department or servicing area that has experience handling SBA loans. Loan source Eligibility, Underwriting & Structuring Packaging & Processing SBA Approval & Closing Loan Sales Post sale accounting & reporting Servicing
61 Profitability Model Lets assume that you hire your underwriting and processing staff and the lending staff brings in $10 million in SBA loans. If the bank sells the 75% portion of the loans that is guaranteed, or $7,500,000, it should earn at least a 12% premium in today s market, or $900,000.
62 Profitability Model (cont.) For simplicity sake, we will exclude interest & servicing income from this analysis. If you can generate the $10 million with an internal lending staff, the bank will only have the $200k processing and underwriting expense and therefore generate $700k in profit.
63 Profitability Model (cont.) If you add in the SBA BDO cost and assume that half of the loans come from brokers, then you are looking at an additional $200k of expense and a reduced profit of $500k, but the bank is much more likely to hit the $10 million production target.