A market that healed itself

When the secondary market froze, small business loans dried up. But in the last few months, the market has come back to life - with little government aid.

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By Emily Maltby, CNNMoney.com staff writer

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NEW YORK (CNNMoney.com) -- Sick of bailout billions? Here's a bit of good news: While the government struggled to come up with a viable recovery plan, one ailing financial market has managed to heal itself.

Small business lending collapsed last year, as loan volumes dropped to half of their previous levels. One of the catalysts was a sudden freeze in the secondary market, where banks sell off bundled batches of loans they've made. When the financial world went into crisis last September, that market came to a standstill, prompting banks turn away small business loan applicants in droves.

Figuring out how to revive the secondary market has been a priority for the Small Business Administration and the Treasury Department. The government set aside billions to invest, vastly eclipsing the money earmarked for other small business stimulus efforts. But while government agencies struggled to get their programs up and running, the market came back to life on its own.

"Back [in January] the market was pretty much considered nonexistent. Jump ahead to July ... it looks to us that while the market isn't 100% back, it's in very good shape," Jim Hammersley, director of the SBA's loan programs, said at a small business lending conference earlier this month.

In the first nine months of 2008, lenders resold a monthly average of $327.9 million of the loans they made through the SBA's flagship 7(a) lending program, according to the SBA. That number declined drastically in the months following, bottoming out at $85.9 million in January.

But in May, secondary market sales abruptly jumped to $324.6 million, and have stayed in that range each month since. A once-frozen market has thawed, creating a glimmer of hope on the otherwise bleak small business lending landscape.

Where the problem started

When banks make loans, some keep the note and collect payments as they come due, profiting off the loan's interest. But there's a faster way for banks to make money on their loans: Sell them off to other investors in bundles known as "asset-backed securities" (ABS). That gives the bank an immediate cash infusion, which it can then use to turn around and make more loans.

Many of the banks that make Small Business Administration-backed loans resell them. In 2007, lenders resold 44% of their SBA loans on the secondary market, totaling more that $4.3 billion.

But the bundles sold to investors also include other loan types, such as mortgages and credit card payments. The housing crisis put the brakes on the market as investors began to realize that many of the bundles they were purchasing were full of toxic loans likely to default. Lehman Brothers' collapse added more fear to the mix.

"There was a lot of uncertainty caused around the time that Lehman went bankrupt," said Bob Judge, partner at Government Loan Solutions in Cleveland, a services provider for SBA secondary market sellers. In August 2008, just before Lehman's Sept. 15 bankruptcy filing, 47% of the SBA's loans were resold on the secondary market. In October 2008, that number abruptly fell to 24%.

Further complicating the market, in the crisis that followed Lehman's collapse, the prime and Libor interest rates fell completely out of synch. This was a particular concern for U.S. banks that based interest rates for their SBA-backed loans on the prime rate, but depended on international investors, who priced their loans on the Libor system, to buy them. While Libor (London Interbank Offered Rate) is historically about three points lower than the prime rate, the two rates fluctuated dramatically at the end of last year. On some days, Libor exceeded the prime rate.

When banks couldn't find secondary market buyers for their loans, the effect was sharp and dramatic. In the last three months of 2008, the number of loans made through the SBA's main lending program fell 57% compared to a year earlier. Other recession-related factors contributed to that drop, but several banks specifically cited the secondary market freeze to explain their lending pullback.

A financial calamity was brewing. In response, the government created an initiative called the Term Asset-Backed Securities Loan Facility (TALF). It allowed secondary market investors to take out low-priced loans from the government to buy ABS pools and get the market moving again.

The Fed originally allotted $200 billion for the program, which kicked off in March and was set to expire at the end of 2009. But TALF got off to a very slow start. In March and April combined, investors requested just $6.4 billion in TALF loans, even though the program was intended to support lending of $20 billion a month.

Even more telling was the program's limited reach. Although investors were eligible to use the funds to purchase several types of securities -- student loans, mortgages, auto loans, credit cards and SBA loans, to name a few -- they were only interested in buying auto and credit card loans for the first two months of the program.

SBA loans weren't attractive to investors because they had a comparatively low return. Lenders often break their SBA loans into parts and only sell off the government-guaranteed portion. Those loans are a completely safe investment -- they're insured by the government against default. Because of that, they carry fairly modest interest rates. That makes it uncommon for SBA loan bundles to have all the ingredients of an attractive pool -- a high interest rate, a high secondary market price, a long maturity and a high TALF return.

"An ABS asset can have an interest rate of, say, 5% and a TALF return of 15% due to the leverage," Judge said. "SBA pools have difficulty achieving 10%-plus levered returns due to their generally low interest rate. This was the initial problem."

A self-healing market

In May, only $86.6 million was requested from TALF to purchase small business loan bundles. June was even more dismal, with small business pools totaling $81.5 million -- less than 1% of the total TALF loans requested that month.

But even as TALF loans didn't flood the market with demand, the volume of SBA loans being traded was rising nonetheless, hitting levels that the market hadn't seen since 2008. Analysts began to notice two fundamental changes. First, interest rate spreads began to find their footing again. Also, new investors started to participate.

"The current investor community is different than few years ago, when foreign investors represented a large portion of the buyers of SBA pools," said Chris Laporte, chairman of Coastal Financial Holdings, at a conference on TALF held last week by trade publisher Coleman Publishing. "They dropped out in '07 to '08 and they've not really come back. [What] started picking up in the first quarter of this year was a more diverse mix of buyers -- a lot of domestic buyers, hedge funds, government buyers and others."

The interest from new investors and the stabilization of the credit markets helped fuel a pickup in the small business secondary market. Another contributor to the recovery was a drop in the return rates for other types of asset pools for investors leveraging their TALF money.

"In the last six weeks, we've seen an increase in flow," Judge said. "The returns on TALF trades for all asset classes have gone from 15% return to below 10%, so that lowers the bar for what constitutes a good transaction for an SBA pool."

TALF's real impact

Investors took $101.6 million and $149.3 million in TALF loans to buy small business loan bundles in July and August, respectively -- a boost from prior months but still a tiny sliver of the overall TALF lending, which totaled $6.9 billion in August.

That has market observers speculating that a recovery would have happened even without government aid. In March, seeing the anemic TALF numbers for small business loan pools, the Treasury Department set aside $15 billion to directly buy SBA-backed loans off the secondary market. That money has so far gone untouched.

Also on ice is a plan, authorized in February's Recovery Act, for the SBA to stimulate the market by making direct loans to broker-dealers. Months overdue, the program remains on the drawing board, but -- like the Treasury's cash stash -- it hasn't been needed.

"The secondary market is back," Laporte said. "Pool sales in the past several months have been brisk. The TALF program hasn't [had] much volume with the 7(a) loans at this point. The recovery is more from the fact that [government programs] are out there and have a PR effect, rather than any substantive effect."

Reports from government watchdogs and industry analysts back that view. Having TALF and similar programs around is helpful, even if their actual use is limited, because it reassures investors that the market will remain liquid, they say.

"The availability of TALF has certainly increased investors' interest in investing in ABS, and it's that interest (rather than the actual usage of the facility) that ultimately benefits the markets and consumers," Standard & Poor's wrote in a recent analysis of TALF. "We believe that a reduction in TALF participation and increased issuance in the cash market points to TALF's success."

Bob Judge also sees value in TALF -- and anything else the government can make available. "The fundamentals of the market are good, but every arrow you have in your quiver is good," he said. "TALF didn't help to the extent they thought it would. But it has started to help a segment of the market, and September may be the highest month we've seen."

TALF's legacy

The government is standing behind TALF. Funding for the program has increased to $1 trillion, and the Treasury coordinated with the Federal Reserve this month to push the deadline for TALF loans from Dec. 31, 2009, to March 31, 2010.

'"The Fed has to wean the asset-backed sector off of TALF and personally, I don't think it will wean off before the end of the year," said DL Auxier, senior vice president and securitization specialist at investment banking firm Morgan Keegan. "Pool assemblers need to have as many options available as they can have."

New investors have been so attracted to the product that there may now be an issue with fulfilling the demand. "We'd like to see more supply at this point," said Coastal Financial's Laporte.

For small business borrowers, a revitalized secondary market is a big move forward -- but it's not, unfortunately, a cure-all. For some banks that relied on the secondary market, its recovery is coming too late. Temecula Valley Bank, which made waves in January when it put its SBA lending program on hiatus, was closed by regulators in July, becoming one of the 81 banks to fail so far this year. CIT Group (CIT, Fortune 500), one of the most active SBA lenders in past years, is trying to stave off bankruptcy and has virtually ceased making new loans.

In the first nine months of its 2009 fiscal year, the SBA's largest lending program backed 49% fewer loans than it did last year. As the Congressional Oversight Panel monitoring the government's bailout efforts aptly noted in a May report on small business lending: "If banks are weak, they cannot participate in the markets even on the terms of the TALF."

Business owners looking for loans are still finding it rough going. But with the secondary market recovering, banks have one less excuse for turning worthy applicants away.  To top of page

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