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Future Is Bright for Secondary Financing Market

A changing tide in the banking industry may make this untapped source of small-business financing a reality.

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If you own a home or have taken out student loans, you're probably familiar with the secondary market for loans, where banks and other institutions sell these loans to other institutions. The lender then makes loan payments to a new creditor, such as Freddie Mac or Sallie Mae, and the original lender uses proceeds from that loan sale to fund new loans.

A secondary market for small-business loans has not progressed as well as those for home mortgages and other financing over the past 10 years, according to a recent study conducted by Washington, DC, financial advisory and investment banking firm Kormendi/Gardner Partners for the SBA. Though Congress passed the Riegle Community Development and Regulatory Act in 1994, hoping to reduce the regulatory barriers to the securitization of conventional small-business loans and make it easier for loans to be pooled together as securities and sold to investors, this market has shown few signs of life, to say the least.

Kenneth Temkin, an economist with Kormendi/Gardner Partners, explains that lenders have essentially not seen a need for this secondary market. "The lenders we spoke with said that their firms had sufficient capital to meet their small-business origination goals without recapitalizing through securitization," says Temkin, a co-author of the study, "An Exploration of a Secondary Market for Small Business Loans." "Moreover they believed that the execution that would result from selling their existing pools of conventional small-business loans would not be high enough to warrant a sale."

Likewise, the loans themselves may not be that attractive to potential buyers. "[When] home mortgage loans are packaged for the secondary market, the values of the assets and the risk of defaults are rather predictable," says Charles Ou, senior economist with the SBA's Office of Advocacy. "Small-business loans are underwritten by different banks under different standards; it is hard to package them for sale to the market."

According to the study, however, increased use of credit scoring--a rating based on a borrower's credit history--may make it easier to sell these small-business loans to a secondary market. "Credit scoring, especially if such systems are used to underwrite loans larger than $100,000, may make it easier to pool conventional small-business loans originated by different lenders since it provides an objective measure of credit risks," Temkin says.

Additionally, the study found bank consolidation could make these loans more attractive to the secondary market. "Lender consolidation may make securitization more feasible since there are larger pools of loans that are originated using company-wide underwriting and documentation standards," Temkin adds.

Looking forward, the development of the secondary market is likely, says Temkin: "The study concludes that recent trends in small-business lending, credit scores and lender consolidation may make a secondary market more feasible in the future in the event of a liquidity crunch."