Recent SBA 7(a) guarantee sales by ValueXpress partner banks confirm tremendous demand from secondary market loan guarantee broker/dealers, even for higher guarantee amounts above the $1.5-million maximum guarantee that existed prior to September 2010. When the SBA 7(a) loan limit was increased to $5 million in September 2010, SBA 7(a) loan guarantees increased to $4.5 million during the period in which the Jobs Act was in place (through March 2011) and to $3.75 million currently.
Initially, secondary market prices for larger loan guarantees above the previous limit of $1.5 million found lower bids relative to loan guarantees under $1.5 million. As the guarantee amount increased, the gap increased between a $1.5-million guarantee bid and a $4.5-million guarantee bid. It was not uncommon to find a $1-million, 25-year term, Prime + 2.75% floating rate, quarterly adjustable loan guarantee bid at 113, while at the same time, a $4.5-million 25-year term, Prime + 2.75% floating rate, quarterly adjustable loan guarantee struggle to receive a 107 bid.
The reason for the bid difference involves prepayment risk the investor assumes when purchasing a loan guaranty at a premium. With SBA 7(a) loans providing weak prepayment restrictions of 5% in year 1, 3% in year 2 and 1% in year 3, if a purchased guarantee pays off early, the investor will suffer a loss on the premium paid to purchase the guarantee. The way this risk is minimized is to invest in a pool of guarantees. If an investment is made in piece of a diversified pool of, say, 40 $1-million loan guarantees, if one or two pays off early, the overall rate of return for the pool is not dramatically affected. But if the same pool consisted of, say, 8 $4-million loan guarantees, one or two early payoffs would have a substantial negative impact on returns.
As a result, larger loan guarantees were bid poorly relative to smaller loan guarantees. However, recently a few broker-dealers have stepped up their bids on larger guarantees, presumably by creating larger balance pools that lower the concentration of larger loan guarantees in the pool. We recently settled on two loan guarantees sales with balances between $2 million and $3 million that received bids at the same level as smaller guarantees, in excess of 113. This is great news for loan guarantee sellers.