March 9, 2016
C-Suite Wednesday — SBA 7(a) Secondary Market Outlook for 2016
By Bob Coleman
Editor, C-Suite Wednesday
Episode 15 — Bob Judge, CEO of Government Loan Solutions
Coleman Small Business Lending Podcast
Today’s guest is Bob Judge, CEO of Government Loan Solutions, Inc. In October 2006, Bob co-founded Government Loan Solutions for the purpose of bringing greater transparency, efficiency, and productivity to the SBA marketplace. Bob is a recognized expert in the valuation of SBA-related assets as well as the SBA secondary market. GLS was acquired by Live Oak Bank in September, 2013.
Bob Coleman: “On September 15, 2008 Lehman Brothers filed for bankruptcy.” Bob wasn’t September 15, 2008 also the day of our first SBA Secondary Market Summit in New York?
Bob Judge: Yes it was, thank god we didn’t have anyone from Lehman there.
Bob Coleman: I think we did a disservice to the 60 people in attendance talking about SBA Secondary Markets. We should have been talking about how to outfit our caves with electricity, air conditioning and a wine cellar.
Bob Judge: Especially the wine cellar.
Bob Coleman: Bob you have carved out a very specialty niche in your profession. I always loved the Jack Welch line, “Where does your parachute end up?” So tell us what you do, what is a secondary market?
Bob Judge: Basically a secondary market is a financial market which in this case allows the sale of small business loans. Lenders need to be able to sell loans in order to make more loans. This is similar to how a mortgage market works. When a mortgage lender makes a conventional loan that is guaranteed by Fannie or Freddie then they sell it to free up capital. It is the same thing with a small business lender. Many of them need to recycle the capital in order to make more loans. If you don’t have a secondary market you are going to have many fewer loans created regardless of whether you have an SBA Loan or a conventional loan.
Bob Coleman: Well we certainly lived in that back in 2009, I alluded to our first Secondary Market Summit when the secondary market seized up with all of these bankruptcies and small business lending plummeted, not only in SBA lending, but nationwide conventional small business lending. How much did we lose in available capital for Main Street in 2009?
Bob Judge: At least 50%. A lot of lenders needed the secondary markets so a lot of them basically had to shut down.
Bob Coleman: Well let’s fast forward to 2016, what does the secondary market look like now, what are we facing?
Bob Judge: If we are looking at SBA 7(a) lending it’s great. In fact the last three years have set a record high for amount of loans sold into the secondary market. In 7(a) lending, the guaranteed portion, last year was the first year we went over $7 billion. So that market is in excellent shape both from a price perspective and a prepayment and default perspective. Turning to the 504 market, that one is in need of a little bit more help. Mostly because it does not have a government guaranty. Even though it is slowly coming back it is definitely nowhere near what it was pre-credit crisis. I would say that is similar with other non-guaranteed sectors. There is still a lot of work to be done getting it back to the pre-credit crisis levels.
Bob Coleman: Let’s define some of these terms, when you say prepayment, what are you talking about?
Bob Judge: There are two elements to prepayment. One is loan defaults. In the case of a guaranteed security that is when the SBA will pay you off. The other element is the voluntary prepayment of the loan where the borrower pays the loan prior to maturity. These things are important to track because most markets trade a premium to par. The people that are buying these loans at a premium need these loans to hang around for as long as possible so they can recoup their premium. If prepays are high it means these loans are paying down quicker and that can be a drag on secondary market pricing and returns earned by investors.
Bob Coleman: Are we at a historical all time low in default rates for small business lending?
Bob Judge: Yes, if we go measurements from SBA, which would be a good indicator for other small business sectors, we are at all times lows for default rates in this case the 7(a) market as well as the 504 market. It is incredible how well the defaults have fallen since the beginning of the credit crisis when they peaked at eight times higher than they are today. Small business lending is in great shape in my mind even in the face of low economic growth, which is a bit surprising.
Bob Coleman: What do we attribute that to? Is it lenders becoming smarter, Main Street becoming more prudent in their borrowing, what do you think?
Bob Judge: I attribute that to lenders being more prudent. I think things got out of control prior to the credit crisis. People are doing a much better job underwriting loans and using a credit box that is much more realistic. I think we are getting much better at what we are doing across the small business lending industry.
Bob Coleman: Is out of control an economic term?
Bob Judge: Ha-ha, it can be in this case.
Bob Coleman: So the next question, is there a bubble, are we at the floor, and is this the best it’s going to be or do you see this trend continuing.
Bob Judge: I see the trend continuing with low defaults, I see no reason why they should change outside of another significant recession. I don’t think we are in a bubble because volumes in small business lending are just now getting back to slightly above pre-credit crisis, it hasn’t gotten crazy. The economy will keep plugging along as it has for the last couple of years. I don’t see any reason why default rates should spike anytime soon.
Bob Coleman: We always see hiccups for example if you are in the oil patch in west Texas or North Dakota or the threat of a $15 minimum wage. How do you see these isolated blips affecting overall performance?
Bob Judge: You will always see industries having difficulty. That is always the case even during good times. On a percentage basis those are relatively small sectors, they are big overall but it is not a huge portion of overall small business lending. It’s a huge concern for people in those industries but from a macro perspective it’s not a huge concern for overall small business lending.
Bob Coleman: You mentioned 504, can you differentiate between a 7(a) secondary market and the 504 secondary market.
Bob Judge: The 504 program is strictly used for owner occupied real estate for example hotels, where houses, and medical buildings. The structure is different than the 7(a) market. Under 7(a) the government guaranty on the loan is up to 75%. On the 504 loan, SBA issues a second mortgage which is a first loss of up to 40%. There is a 10-15% equity injection by the borrower. Then there is a first lien typically with a 50% loan to value. The first lien can be sold into the secondary market by lenders. Because of the lack of the government guaranty specifically on that loan, the 504 secondary market has not returned to pre-crisis levels. On the second lien, every month SBA securitizes all the ones issued the previous month and sell securities through Bank of America and Credit Suisse. So that side is pretty well taken care of. But it is that first lien on the secondary market that has not done as well as it should have since the end of the credit crisis.
Bob Coleman: We have a new wrinkle to the market. If you are a Main Street entrepreneur and you own your building and you finance on a conventional basis, a lot of those loans have a maturity, a call at five or ten years. Congress has re-instated a refinance program for 504, how important is that to the program and to the secondary market?
Bob Judge: It’s vital to the program. The 504 program has really shrunk in size since the beginning of the credit crisis. One of the reasons is a lack of the secondary market. The refi elements will add significantly to new originations into the 504 market which can only help, bigger volumes are always beneficial. That should help get the secondary market going stronger than it is currently. The 504 program really needs that help to get it up and running again.
Bob Coleman: How important are alternative (FinTech) lenders to Main Street?
Bob Judge: I think they are very important. Anytime you have new types of financial vehicles it’s beneficial for small business borrowers to borrow money. I think they have added a lot to the small business lending industry. Anytime you can add means for small businesses to access capital, it’s beneficial for Main Street.
Bob Coleman: How are these institutions funded? Do they have a true secondary market that we are familiar with?
Bob Judge: A lot of them are involved with hedge funds or large institutional investors who are buying those loans. It’s not so much a peer to peer market, it’s with a hedge fund or large institution who can do that analysis. There is an opportunity there so there are large investors interested. There seems to be ready demand for the product. There has been some securitization done so there has been a budding call for a secondary market for the paper, especially as the sector matures and people get a good handle on performance from a credit perspective. You can see that this market is starting to mature because rates being charged are starting to come down as people start to get a better understanding of this product.
Bob Coleman: Also you are seeing Wall St. banks embracing this product. Chase announced a partnership with OnDeck Capital. You are seeing a lot of community banks buying this paper. Should traditional brick and mortar lenders be threatened by these lenders? I say no because they are finding ways to participate in this paper.
Bob Judge: They are targeting a sector that banks do not want to participate in. For loans under $350,000, it’s too expensive for traditional banks to make. Banks are getting smart by letting the online lender make the loans so they don’t get involved in the credit side, but they are eventually buying it directly or in securitizations. They are getting involved without having to fully make those loans.
Bob Coleman: I have a different take, I say SBA has become a disruptor in that under $350,000 niche. Under $25,000 they have basically made it an unsecured product. Under $350,000 they have made it a lot less onerous in terms of what they require. Now the regulators might not agree with that but that is whole different subject. There is a lot of effort in getting capital to the under $100,000 loan market. That has been missing for the last ten years dramatically.
Bob Judge: I agree, SBA has done a good job of trying to stimulate loans under $350,000. Making it less onerous to make the loan and making a credit model is lowering the average balance of an SBA loan. Instead of everyone doing $5M or higher, SBA loans can be used for pizza places and are driving economic growth.
Bob Coleman: How do you monetize Government Loan Solutions?
Bob Judge: Essentially we do three things. We send most of our efforts in the SBA markets, specifically 7(a) is our big driver. He help lenders sell the guaranteed portion of 7(a) loans into the secondary market. About 25% of the market flows through us. He have 150 clients that use us. Secondly, we are the valuation experts of the industry. We provide valuation servicing rights for any other type of small business loan to participants. And lastly, we are the data providers to the industry. We have been tracking 7(a) data for 20 years pre-GLS. We know things like default rates, payment history, and geography for the 7(a) and 504 programs going back many decades. People utilize our services from valuation to execution.
Bob Coleman: You are being humble, you are recognized by SBA and the regulators as the experts in this arena. When the bank hires you the regulators feel very comfortable with the services you provide the lenders.
Bob Judge: I see it as a partnership all around. Making the market better for all investors and lenders as well as regulators.
Bob Coleman: You and I are big believers in transparency. The more that we can get the data out there the better loans the lenders can make and that is better for everyone else involved.
Switching it up, you were once a suit. You became an entrepreneur and now you are back to being a suit. You sold out to Live Oak Bank, tell me about that transition.
Bob Judge: Well I sold the company to Live Oak Bank but I do not have to wear a suit. Just reserved for weddings and funerals.
Bob Coleman: And graduations?
Bob Judge: Yes they are getting degrees and hopefully moving into adulthood soon.
Bob Coleman: How is it being affiliated with the innovative Live Oak Bank?
Bob Judge: It is really great company, as you said they are innovative and a great bank. It is more like a tech company rather than a banks as far as how they look at the world. Very technology intensive. They were the number two 7(a) lender in the country last year which is amazing considering they were bigger than everyone except for Wells Fargo. I’ve appreciated being with them and hope to continue.
Bob Coleman: Bob, if I am a Main Street entrepreneur, why would I care about what Dodd-Frank is doing to the lenders? Why should I care about a Consumer Finance Protection Board? Why should I care about what FASB will do to loan loss reserves up front, can you touch on those briefly.
Bob Judge: The increasingly regulatory world, I am not going to discuss why that is good or bad. Obviously those things have an impact on the ability to make loans and reporting issues. CFPB is watching out for companies taking advantage of consumers and small businesses. Obviously online lenders need to be aware that things are coming their way on a regulatory perspective. When you are in a regulated institution you have to deal with an environment with increased regulatory scrutiny. You have to work around that and make sure it doesn’t hurt your business in any way.
Bob Coleman: Will the lenders adapt and still have capital available for Main Street?
Bob Judge: It’s either adapt or die. If someone cannot make it, it will be filled with someone who can adapt.
Bob Coleman: Two more softball questions. We are talking after Super Tuesday, what would be the impact of a Hillary Clinton Presidency on the secondary markets?
Bob Judge: I don’t think there will be a significant impact. A continuation of the policies adopted by the Obama administration, who has been very supportive to the SBA.
Bob Coleman: The bi-partisan support of Congress to increase the 7(a) levels is indicative of the next Congress’ support, what would a Trump Presidency be like for secondary markets?
Bob Judge: I think he supports small business, he is a businessman himself. I don’t see any negative impact. The great thing about SBA lending is that it is a zero subsidy program so anytime a program doesn’t cost the government money it’s a much easier conversation on both sides of the aisle. I think that is why the program gets so much support. It’s not a huge program that pays for itself so either candidate would not have a negative impact on it.
Bob Coleman: The budget is actually decreasing every year because the loans are defaulting less and you know one of my favorite sayings is ‘SBA didn’t need a bailout.’ Bob Judge, Founder, Government Loan Solutions.
Bob Judge: Thanks Bob.