market strategies - cbai sba primer.pdftotal outstanding agency cmbs $bn source: bloomberg l.p. 0%...

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Market Strategies

September 2014 | A Primer on Small Business Administration Securities (SBA)

Drew SimmonsVice President

Financial Strategies [email protected]

405.415.7226

A Primer on Small Businesss Administration Securities (SBA)

OverviewCreated in 1953, the Small Business Administration (SBA) is an independent agency of the United States with the goal of providing financial assistance to small businesses. Similar to the role of Ginnie Mae in the U.S. mortgage market, the SBA does not directly originate loans. Instead, the agency provides a platform for various loan guaranty programs. Participating lenders in the SBA loan programs can opt to sell the guaranteed portion of their loans which are securitized and sold to investors. These securities are backed by an unconditional 100% U.S. government guarantee for the timely payment of principal and interest. Therefore, bank regulators assign a 0% risk weighting to SBA securities. SBA pools can offer investors exposure to the commercial lending market without taking on the credit risks associated with direct commercial lending. Pools securitized by the SBA loan programs include:

• SBA 7(a) PoolsThe majority of these pools are adjustable, indexed to the Prime Rate with 5-25yr maturities paying principal and interest monthly. Pools with maturities of 15yrs or longer have an initial 3yrs of prepayment protection if the borrower pays more than 25% of the outstanding balance. Prepayment penalties start at 5% for the first year, 3% in the second year and 1% in the third. The biggest advantage of SBA 7(a) pools is the adjustable rate structure which tends to increase voluntary prepayments as rates rise and decrease prepayments as rates fall. The biggest disadvantage is the pools have small loan counts that can translate into volatile prepayments.

• SBIC PoolsThe collateral backed by these pools are funded by privately owned venture capital funds called Small Business Investment Companies (SBIC) licensed and regulated by the SBA. All outstanding pools have 10yr maturities and pay fixed semi-annual interest with no scheduled principal until maturity. The best advantages of the SBIC structure is the shorter final maturity and large loan counts. However, SBIC pools have no call protection features and prepayments can be sporadic.

• SBAP 504 DCPC PoolsDevelopment Company Participation Certificates are backed by the 504 loan program via private corporations authorized by the SBA called Certified Development

Companies (CDC). SBAP DCPCs are fixed rate, pay semi-annual principal and interest payments and comprise mostly of 20yr terms with a small percentage of 10yrs available. Compared to the 7(a) program, SBAPs offer more prepayment protection with prepay penalties starting at the debenture rate, then declines by 1/10th each year after origination for 20yr pools. This is the biggest advantage of SBAPs which translates into more stable prepayments. The biggest disadvantage is newly issued pools expose the investor to extension risk.

Exhibit 1: SBA Pools - Advantages & Disadvantages

SBA MarketSBAP, SBIC, and SBA 7(a) pools represent approximately 20% of all outstanding Agency CMBS/ABS products available in today’s market. As shown in Exhibit 2, $43.2B in SBA 7(a) pools are currently outstanding followed by $27.3B in SBAPs and $7.3B of SBIC securities. While the 7(a) loan pools are the largest segment of SBA related pools, they can have liquidity issues in the secondary market due to the small loan counts that create the potential for unwanted prepayment volatility. If there were a Mega market or larger loan counts per pool, the variable rate structure of SBA 7(a) pools would be a much more attractive product. Figure 1 at the bottom of page 3 provides a brief overview for each of the SBA products discussed herein.

Exhibit 2: CMBS/ABS Related Products

$0 $20 $40 $60 $80 $100 $120

FNMA DUS

FREMF (K-Certs)

GNR (Project Lns)

SBA 7(a)

FNMA GeMS

SBAP

SBIC

$114.5

$76.6

$73.5

$43.2

$38.3

$27.3

$7.3

Total Outstanding Agency CMBS

$BnSource: Bloomberg L.P.

0% Risk Weighting Smaller Loan Counts Most with No Collar, High or No Caps Less Liquid Adjustable Rate pools - less convexity Limited Prepay Protection (only 3ys)

0% Risk Weighting No Prepayment Protection Fast Growing Sector Volatile prepay speeds Shorter Stated Final Maturity Higher Default Rates

0% Risk Weighting Limited Collateral Detail in Secondary Mkt Liquidity New Issue Pool Extension Risks Prepayment Protection (5-10yrs) Limited Supply of Seasoned Pools

Advantages Disadvantages

SBA 7a Pools

SBIC Pools

SBAP 504 DCPCs


Market Strategies


Exhibit 4: SBA 7(a) Prepayments

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20142013201220112010200920082007200620052004

SBA 7a Pools by Original WAM 2004-2014 Originations

ALL <8yr WAM 8-11yr WAM 11-16yr WAM 16-21yr WAM >20yr WAM

CPR

Source: Bloomberg L.P.

SBIC PrepaymentsWithout any prepay protection features within the SBIC program, prepayments are more volatile and voluntary prepays stem more from a company buyout or an initial public offering rather than a decision to refinance. As a result, SBIC prepayments aren’t necessarily driven by interest rates. However, this also makes it difficult to project future cash flows. The most pronounced years of high prepay activity within SBIC pools occurred in 2011-2012 and in 2005. As shown in Exhibit 5, during 2011-2012 voluntary prepayments drove most of the prepay activity while in 2005, a noticeable spike in defaults was the culprit. With no scheduled principal until maturity, SBIC prepays tend to accelerate after year 5 and will have paid down approximately 25% of the balance by year 6. Exhibit 6 shows an average 9.2 CPR for the first 5yrs of the SBIC’s term while the remaining 6-10yrs average 35.2 CPR resulting in a life speed of 21.5 CPR.

Exhibit 5: SBIC Prepayments by Type

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Aggregate SBIC Prepayments

Defaults Voluntary Total CPRSource: SBA, Bank of New York Melon

Exhibit 6: SBIC Prepayments by Seasoning

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6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96 102 108 114 120

CPR

Aggregate SBIC Prepayments by Seasoning


Average CPR Years 1-5: 9.2 CPR


Pools backed by the SBA 7(a) loan program are issued periodically throughout the year with a minimum $1mm pool size and at least 35 loans in each pool. SBA 7(a) pools can also be issued as IO strips as well as WAC pools. SBIC pools are issued semi-annually with $500-$600mm pool sizes and 100-200 individual loans/debentures. SBAP 20yrs are issued every month with pool sizes of $220-$470mm and loan counts north of 400. The 10yr SBAPs are issued every other month with a $25mm average pool size and typically 40-80 loans in each security.

Prepayment AnalysisAll three of the aforementioned SBA pools can prepay through voluntary prepayments at the borrowers option or accelerated prepayments by way of default. According to SBA data since 1999, defaults represent about 1/4th of all prepayments. Exhibit 3 below shows the aggregate 12mo CPR for SBA 7(a), SBAP and SBIC pools since 2004. Speeds from SBAP pools tend to have the most stable prepayments in both rising and falling rate environments while SBA 7(a) and SBICs are more volatile.

Exhibit 3: SBA Prepayments - Avg 12mo Speeds

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

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o CP

R

Aggregate Prepayments by SBA Product

SBA 7a Variable SBAP 504 DCPC SBIC PoolsSource: SBA, Bank of New York Melon

SBA 7(a) PrepaymentsSBA 7(a) speeds consistently pay faster during periods of rising rates and slower when rates are low. Unlike their SBIC counterparts, aggregate prepayments for the sector as a whole are more predictable. Their behavior is largely driven by changes in interest rates due to the variable rate structure of the underlying loans. However, for an individual security, it is difficult to obtain a smooth cash flow profile. On average, there are only 35 loans in SBA 7(a) pools. In Exhibit 4 we can see that the most recent period of fast prepayments came in 2006-2007, the last stretch of elevated interest rates prior to the Great Recession. If interest rates were to rise again, speeds on the SBA 7(a) pools should begin to pay at a faster rate. For an additional layer of call protection, investors should look toward SBA 7(a) pools with original maturities greater than 15yrs which provide a 3yr window of prepayment penalties. As shown in Exhibit 4, pools with original WAMs of 16-21yrs have the most stable prepayment profiles.

INTENDED FOR INSTITUTIONAL INVESTORS ONLY. The data provided in these reports is for informational purposes only and is intended solely for your private use. Information herein is believed to be reliable but The Baker Group LP does not guarantee its completeness or accuracy. Opinions constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your Baker representative. The investments discussed may fluctuate in price or value. Changes in rates of exchange may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.


Market Strategies


Amortizing - Variable 5-10yrs (Non Real Estate) Prepay Penalties (>15yrs Only) Min: 4 Loans - $1mm Various Purposes - Expansion,Spread + Prime 25yrs (Real Estate) 5% - 1st Year | 3% - 2nd Year | Avg: 35 Loans - $10mm New Construction, Equipment,Monthly P&I Most Pools are 25yrs (60%) 1% - 3rd Year | WAC or IO Strips Land/Buildings, Working Capital

Amortizing - Fixed 10yrs (Machinery/Equipment) Prepay Penalty Beg. @ Deb. Rate* Avg 20yrs: 500 Loans - $280mm Land/Buildings/Physical PlantsCoupon Rate = Deb. Rate* 20yrs (Real Estate) 20yrs: Decreases 1/10th per year Avg 10yrs: 50 Loans - $25mm Machinery/EquipmentSemi-Annual P&I Most Pools are 20yrs (97%) 10yrs: Decreases 1/5th per year 5% CPR Pricing Convention EXCLUDES: Working Capital

Interest Only - Fixed 10yrs Avg 100-200 Individual Debentures Various Purposes - OperatingTemp. LIBOR Based Rate 15yrs Avg $500mm-$600mm deal size Capital, Business Acquisitions,Semi-Annual Interest Current Pools are all 10yrs 7% Pricing Convention Research and Development

* Deb. = Debenture Rate

SBA 7a Pools

SBAP 504 DCPCs

SBIC Pools

0%

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0%

No Prepayment Protection

Risk WeightingStructure Terms Prepayment Protection Pooling Collateral

Figure 1: SBA Products & Features

SBAP PrepaymentsPrepays within SBAP pools are relatively more consistent over time due to the embedded prepay penalties that extend through half the life of the underlying loans. Since 2000, the fastest period of aggregate SBAP prepayments occurred in the low rate environment of 2003-2004. During this period, the bulk of these speeds were in the form of voluntary prepayments as shown in Exhibit 7 below. Exhibit 7: SBAP Prepayments by Type

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CPR

Aggregate SBAP Prepayments


Similar to SBIC prepayments, SBAP speeds progressively ramp up as the pools near mid-term. Exhibit 8 shows an average 10.4 CPR for the first 10yrs of 20yr SBAP prepayments followed by an average 19.5 CPR for the remainder of the term. Unlike SBICs, defaults play a much smaller role with the biggest percentage of defaults occurring in 2010 where the Constant Default Rate (CDR) reached 7.6%. SBIC defaults peaked in 2005 with a CDR of 13.3%. As a result of better prepayment protection and lower defaults, SBAP pools are slower with an average life speed of 14.8 CPR for the aggregate 20yr terms shown in Exhibit 8. However, SBAP pools share the same benefits as SBICs with large loan counts that can help smooth out erratic prepay behavior. While 10yr pools are available, the loan counts can be substantially lower. Of the last 10 SBAP 20yr and 10yr pools issued, the average loan count for 20yrs was 441 while 10yr terms had an average 57 loans per pool.

Exhibit 8: SBAP Prepayments by Seasoning

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12 24 36 48 60 72 84 96 108 120 132 144 156 168 180 192 204 216 228 240

CPR

Aggregate SBAP Prepayments by Seasoning




Relative ValueToday, the best relative value in SBA pools for institutional portfolios is within seasoned SBAP 20yr debentures. Newer issued SBAP 20yrs have 55-60bps of spread over the interpolated treasury curve, with average lives of about 7yrs when priced at 10 CPR. Given these newer issued pools are a little long for the average portfolio, investors should seek seasoned pools with shorter average lives. Exhibit 9 is an example of a 60mo seasoned 20yr SBAP yielding 73bps over treasuries and an average life around 5.32yrs when priced at 10 CPR. With a 108-13 premium dollar price, the 5yrs of prepayment penalties offers solid call protection if rates fall. Such structures offer investors an opportunity to diversify the portfolio with exposure to the commercial lending market and a 0% risk weighting.

Exhibit 9: Seasoned SBAP 20yr Yield Table

market strategies - cbai sba primer.pdftotal outstanding agency cmbs $bn source: bloomberg l.p. 0%...

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