CPR Report Special Edition
WHAT IS GOING ON? SOME THOUGHTSBy Bob Judge
Due to the historic events of the past two weeks, I felt it was necessary to go beyond our usual data analysis and discuss how these events have, and will, impact the SBA industry. Hopefully, I can bring some light onto what is going on, as well as suggest what might happen in the future.
As we all know, global fixed income markets are experiencing unprecedented disruptions. No sector has escaped the punishment, including the SBA secondary market for loans and pools. Secondary market loan prices have been falling since August and crashed last week, to the point where bids are either extremely low, or non-existent.
What has caused the SBA secondary market to contract?
I will not go into an explanation of the global financial turmoil; there are enough talking-head economists out there to handle that job. I will concentrate on the causes of the problems within the SBA industry.
One would think that a government guaranteed asset, such as SBA loans and pools, would be in demand during times of market stress. Certainly this can be said for the US Treasury and conventional MBS markets, but not for SBA guaranteed assets.
Why not?
Let’s now turn to the reasons why SBA assets have underperformed.
It begins with the current state of global money markets, as expressed in the inflated spread between US$ Libor rates and the Fed Fund target rate. For a number of years prior to mid- 2007, the spread between 1 month and 3 month Libor rates and Fed Funds was 7 basis points. It has been elevated ever since, reaching an all-time high of 200 and 215 basis points, as of the writing of this article.
Why has this occurred?
Libor is the rate at which banks lend to other banks on an un-secured basis. So, the Libor/Fed Funds spread can be seen as an indicator of the credit-worthiness of the global banking industry. As we all know, the current financial state of the global banking industry is poor. For this reason, banks are demanding ever-higher rates in order to take on the credit risk of other banking institutions.
What does this have to do with SBA assets?
While elevated Libor rates are a by-product of global financial distress, they are the root cause of the problems in the SBA secondary market. Due to the pervasive use of Libor as a benchmark rate for many loans and credit lines, most investors fund themselves on a Libor basis. Additionally, most floating rate assets are quoted and trade on a spread to Libor.
As the Libor/Fed Funds spread rises, two bad things happen.
The first is that as investors funding costs rise, the yield on floating-rate assets has to rise in order to create a positive spread to their cost of funds. Secondly, SBA-comparable assets trade at a spread to Libor. Currently, many of these assets are at record-high spreads. For this reason, the yield on SBA assets has to rise in order to compete with these similar asset classes.
One area that is most heavily impacted is the ability to sell at par for servicing. These loans are then securitized into “par” pools at a negative margin to Prime. In the past, when the Libor/Fed Funds spread was 7 basis points, par pools were created in the Prime – 2.65% range, yielding approximately +28 basis points to Libor. Today, with Libor hovering around 4%, those same pools would yield -165 basis points to Libor. For this reason, the “par” pool coupon has been increasing (less negative), to the point where it is probably somewhere between -1% and -1.50%. For many lenders, they cannot, or will not, sell at these levels.
As to premium sales, the same is true. As Libor rises, the yield on SBA loans and pools also have to rise, whether or not they are stripped and placed into par pools.
Of course, the SBA lending industry is not the only one that is being impacted by these events. As it stands, elevated Libor rates are taking a major toll on the global banking system. Central Banks are filling the liquidity gap, but this cannot go on forever. Global money markets have to be fixed and the only way to do that is to help banks repair their balance sheets so that other financial institutions are willing to lend to them at lower rates.
How long will it take to repair the banking industry?
Again, a good question for the myriad of economists around the world, but I will offer up my thoughts. To begin, the passing of the rescue bill, however imperfect, is a good place to start. Allowing banks to sell distressed assets should help them attract and build capital, which would improve their balance sheets. Improving balance sheets will create confidence and greater confidence will lead to a lower spread between Libor and Fed Funds.
If the US Treasury is pro-active, many of the distressed assets in major banking institutions will be owned by taxpayers within six months to a year. During this entire time, the Libor spread should decline.
In conclusion, I believe that we have turned the corner on the credit crisis with the passing of the rescue bill in Congress. It will likely be a rocky road back to normalcy, but the financial markets will be increasingly more functional throughout 2009.