In order to provide a perspective of how the 7(a) markets compare with other secondary markets, we compared the two secondary markets in 7(a) loan portions to the secondary markets for single-family residential mortgages as follows:
The secondary market for single-family residential mortgages which has federal mortgage insurance provided by the Federal Housing Administration (FHA), a government corporation within the Department of Housing and Urban Development (HUD). Secondary Loan Markets Generate Benefits and Concerns

Secondary loan markets, which are resale markets for loans originated in primary markets, link borrowers and lenders in local markets to national capital markets, lower costs for funds, and help lenders manage risks. This linkage provides an additional source of funds for lenders that can increase lenders’ liquidity. The share of loans in a primary market that are sold in a secondary market depends on the benefits generated by the secondary market. The Secondary Markets in SBA 7(a) Loans Generate Benefits and Risks

In linking 7(a) borrowers and lenders from local markets to the national capital markets, the 7(a) secondary markets--particularly the market for guaranteed portions--benefit lenders, borrowers, and investors. The 7(a) secondary markets can help borrowers and lenders by reducing regional imbalances and cyclical swings in credit availability and pricing. Investors in the guaranteed 7(a) market face prepayment risk, and investors and lenders in the unguaranteed 7(a) secondary market share prepayment and credit risks. The 7(a) Secondary Markets Generate Benefits for Many Depository and Nondepository Institutions

In calendar year 1997, 1,540 SBA lenders sold 12,164 7(a) loans (about 45 percent of the 7(a) loans approved during the most recent fiscal year) in the guaranteed secondary market and collectively generated $2.7 billion in sales. These lenders generally lacked a sufficient deposit base to fund their loans. Investors in 7(a) pool certificates and securities benefit from greater liquidity and lower risks than they would get from investing directly in individual loans, because these instruments can be sold more easily than individual loans, and risks are dispersed among the pooled loans. Although the 7(a) Secondary Markets Help SBA Serve Small Business Borrowers, They Provide a Means for Concentration of Credit Risk

The 7(a) secondary markets could also be instrumental in contributing to a concentration of credit risk for SBA. Compared to the secondary markets for 7(a) loans, the secondary markets for residential mortgages operate with greater incentives for lenders to sell the loans they originate. In 1997, about 11 percent of unguaranteed portions of 7(a) loans were sold in the secondary market compared to about 32 percent of nonconforming loans sold in the secondary mortgage market. Lenders participating in these markets can reduce funding costs, and they can pass along some of their savings in the form of more favorable loan terms to borrowers. In 1997, about $290 million in unguaranteed portions of SBA loans were sold on the secondary market compared to $2.7 billion dollars in guaranteed portions. Generally, securitizations of small business loans without federal guarantees have been limited. A final rule, promulgated February 10, 1999, and effective April 12, 1999, generally requires that a securitizer have sufficient capital to meet the definition of “well-capitalized” used by bank regulators (depository institution), or maintain a minimum applicable capital equal to at least 10 percent of its assets, excluding the guaranteed portion of its 7(a) loans and including any remaining balance in its portfolio or in any securitization pool (nondepository institution); retain for 6 years a subordinated interest in the securities, the amount of which is the greater of two times the securitizer’s loss rate on its 7(a) loans disbursed for the preceding 10-year period or 2 percent of the principal balance outstanding at the time of the securitization of the unguaranteed portions of the loans in the securitization; and be placed on probation for one quarter, and then suspended for at least 3 months from preferred lender status if the securitizer’s default rate crosses certain thresholds and fails to improve to SBA’s standards.
Why GAO Did This Study

Pursuant to a congressional request, GAO provided information on the secondary markets for 7(a) small business loans guaranteed by the Small Business Administration (SBA), focusing on: (1) the benefits and risks of secondary loan markets to participants; (2) primary benefits and risks to participants in the guaranteed 7(a) secondary market and the unguaranteed 7(a) secondary market; and (3) a comparison of the guaranteed 7(a) secondary market with the secondary market for federally guaranteed residential mortgages, and the unguaranteed 7(a) secondary market with the secondary market for residential mortgages without a federal guarantee.

What GAO Found

GAO noted that: (1) the proportion of loans that are sold in a secondary market depends on the benefits generated by the secondary market and how the benefits and risks are distributed among market participants; (2) by linking borrowers and lenders to national capital markets, secondary markets benefit lenders, borrowers, and investors; (3) these markets: (a) tap additional sources of funds; (b) reduce dependence on availability of local funds; (c) help to lower interest rates paid by borrowers; and (d) help lenders manage risks; (4) they provide lenders a funding alternative to deposits and, by enhancing market liquidity, they can reduce regional imbalances in loanable funds; (5) secondary loan markets can benefit borrowers by increasing the overall availability of credit in the primary market and by lowering the interest rates borrowers pay on loans; (6) the secondary markets in 7(a) loans provide lenders a funding source that otherwise would not be available; (7) in calendar year 1997, 1,540 SBA lenders sold 12,164 SBA 7(a) loans in the guaranteed secondary market, generating $2.7 billion in sales of guaranteed portions; (8) about $290 million in sales of unguaranteed portions were made that year by a smaller number of lenders; (9) these were generally Small Business Lending Companies, which lack a deposit base, or banks that had not developed a sufficient deposit base as a funding source for their loans; (10) lenders participating in these markets can reduce funding costs, and investors in 7(a) pool certificates and securities can get greater liquidity and lower risk than they would from directly investing in individual loans; (11) in the guaranteed 7(a) market, investors face prepayment risk, and in the unguaranteed 7(a) secondary market, investors and lenders share prepayment and credit risk; (12) both 7(a) secondary markets can help lenders make more loans, which could contribute to a concentration of SBA's credit risk among a few lenders that originate a large percentage of 7(a) loans; (13) compared to the secondary markets for 7(a) loans, the secondary markets for residential mortgages operate with greater incentives for lenders to sell the loans they originate; (14) in 1997, about 45 percent of the guaranteed portions of 7(a) loans originated that year were pooled and sold on the secondary market compared to virtually all federally insured single-family residential mortgages; and (15) about 11 percent of the unguaranteed portions of 7(a) loans originated in 1997 were pooled and sold on the secondary market compared to about 32 percent of nonconforming residential mortgages.