CREDITRISK

SECONDARY-MARKET
OPPORTUNITIES IN BY THOMAS WALLACE
AND JORDAN BLANCHARD

SBA 504 LENDING

The 504 loan product of the U.S. Small
Business Administration provides lenders
with a risk-mitigated credit extension that
can be applied to a wide range of borrow-
ers who need financing for capital assets.
The current renaissance of a second-
ary market for 504 loans offers a way to
enhance their marketability as a product

16 The RMA Journal May 2017 | Copyright 2017 by RMA

TABLE 1: STANDARD STRUCTURE OF A 504 LOAN
LENDER PARTICIPATION PERCENTAGE & SECURITY POSITION
50%
Private Sector First position on all financed assets, other assets as available/required.
30-40%
CDC Second position on all financed assets, other assets as available/required.
Borrower 10-20%
Injection may be financed under certain regulatory and credit considerations.
by customizing the credit structure to fit the bor-
rower’s needs. Secondary markets also allow the
lender to manage issues related to the balance
sheet and revenue recognition.
Program Overview
The SBA’s 504 loan program is a public-private
partnership involving a certified development
company (CDC), an SBA-licensed and -regulated
entity, and virtually any private-sector lender. Ap-
proximately 225 CDC licensees operate across the
country, frequently as adjuncts to local economic
development efforts.
SBA 504 allows a private-sector lender to partic-
ipate out to a CDC a junior tranche of a loan for the
acquisition of and costs related to capital assets,
subject to SBA eligibility. The standard structure,
shown in Table 1, allows a qualified borrower to
make an equity injection that is smaller than gen-
erally contemplated in conventional loans.
The private-sector loan, while being well se-
cured in first position on some 50% of the project’s
cost, does not carry a direct federal loan guarantee.
On the other hand, this loan is free of the heavy
compliance burden associated with preserving the
federal guarantee under the SBA’s 7(a) program.
The compliance requirements for the private-
sector loan are largely contained in a single SBA
document and are not dissimilar to those required
by any participant in a conventional loan.1 Pric-
ing is essentially unregulated beyond a maximum
rate.2 The private-sector loan must provide a term
of at least 10 years for a 20-year SBA-backed sec-
ond-position loan. However, there are no specific
requirements for amortization.
The junior loan, backed by the SBA and moni-
tored on its behalf by the CDC, provides the direct
FACTORS
Can be less than 50%, under
limited circumstances, with
no specific upper limit.
Reduced by specific require-
ments for borrower equity, can
never exceed the private-sector
exposure, and can exceed $5
million only in specific cases.
Starting from 10%, increasing
in cumulative increments of
5%; applicable to start-ups or
special purpose structures.
impact of the 504 loan program. The loan is fully
amortizing over either a 10- or 20-year term and
carries a fully fixed rate of interest. (The choice
of term is effectively driven by the useful life of
the capital assets being financed, using IRS defini-
tions of useful life.) The rates—set at auctions held
monthly for the 20-year offering (Figure 1) and
every other month for the 10-year offering—are
highly correlated to the 10-year U.S. Treasury bond.
The funding of the two loans is sequential, with
the originating private-sector lender making a loan
to accomplish the transfer of title to the subject
capital assets. A prudent lender will make sure the
borrower’s complete equity requirement is injected
at this closing.
The complete permanent financing is thus
structured as two loans: the proposed first-position
loan, which the private-sector lender may hold
or sell into the secondary market, and an interim
(or “swing”) loan. The interim loan is written to
mirror the loan amount of the proposed junior
loan backed by the SBA. That loan is acquired by
the CDC through the sale of an SBA-backed de-
benture into a highly structured secondary market
at monthly auctions for 20-year term debentures.
If construction or significant renovation work is
required, a construction loan agreement is execut-
ed and the funds from it are added, as needed, to
the first and second loan notes and related security
instruments to preserve the proportionate expo-
sures for the loans as required by SBA regulations.
Program Benefits
The limited equity injection from qualified small
business borrowers provides them with an imme-
diate financial benefit and incentive. The stability
a small business gains from owning its place of
May 2017 The RMA Journal 17
 FIGURE 1: RATES SET AT AUCTION FOR THE 20-YEAR OFFERING to accommodate either expectations of
504 20 Year Debenture Offering occupancy or the need to manage debt
8.00%
8% 504 20 Year Debenture Offering service requirements through a longer
8.00% amortization.
7.00%
7% A common feature in the secondary
7.00% market is also the ability to prepay up
6.00%
6% to 20% of the outstanding loan balance
6.00%
annually without incurring prepayment
5.00%
5%
penalties. These structures exist side by
5.00%
4.00%
side with the long-term, fixed-rate pricing
4%
4.00%
R2R²==0.9007
0.9007 of the second-position loan, providing a
3.00%
3% R² = 0.9007 borrower with an inherent rate hedge.
3.00%
2.00%
2% Strategies for Secondary-Market
2.00% Participation
1.00%
1% Lenders offering secondary-market op-
1.00% tions can use this array of structures and
0.00%
0%
Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Sep-16
pricing modes to uncover and address
0.00%
Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Sep-16 very specific borrower concerns, pro-
Sep-06Debenture
Sep-07RateSep-08 10
Sep-09 Sep-10 Sep-11
Year T-Note Sep-12
Spread Over T-Note Sep-13 Poly.
Sep-14 Sep-15
(Debenture Rate) Sep-16
R2 = 0.9007 R2
= 0.9007 R2 = 0.9007 viding a marketing edge that cannot be
Debenture
DebentureRate
Rate 102 Year T-Note
10-Year
R T-Note
= 0.9007 Spread
Spread Over
OverT-Note
T-Note Poly. (Debenture
Policy Rate)Rate)
(Debenture
overstated. This edge accrues particularly
Chart and Statistical Data is from September 2006 to January 2017
to the benefit of community banks, whose
Chart and Statistical Data is from September 2006 to January 2017
Debenture Rate 10 Year T-Note Spread Over T-Note internal treasury operations often cannot
Jan 2017 2.82% Rate 102.38% 0.44%
Debenture Year T-Note Spread Over T-Note match the resources of money center or
Jan 2017 2.82% 2.38% 0.44%
business
Meanand/or critical3.66%
equipment has2.86% fixed rate, and a junior collateral position.
0.80% super-regional competitors, particularly
equal appeal.
Median
Mean 3.24%
3.66% 2.86% The secondary
2.65% 0.80%market for 504 private-
0.62% in an environment of rising interest rates.
STDev
An additional
Median layer0.012522692
of 3.24%
stability for the0.009626853
2.65%sector loans 0.005569379
is0.62%
based on the ability to sell The off-balance-sheet participation of
STDev 0.012522692 0.009626853 0.005569379
borrower is added by the reduction in SBAthem
For Further on a nonrecourse
504 Information, Contact: and servicing- potentially both the first and the second
refinancing risk due to the low loan-to-Tom
ForWallace
Further SBAreleased basis.Contact:
At the point of sale, all
twallace@idscorp.org
504 Information, loans also provides the lender with the
Margaret Guzinski mguzinski@idscorp.org
value ratio of the first-position loan andWallace
Tom servicing responsibility, revenue, and
twallace@idscorp.org capacity for either extending additional
William
MargaretRidgeway
Guzinski wridgeway@idscorp.org
mguzinski@idscorp.org
the fully amortizing term of the second-Jeff Freeman costs accrue to the account of the buyer.
jfreeman@idscorp.org working capital to the same borrower
William Ridgeway wridgeway@idscorp.org
position loan. Finally, the long-term fixed
Jeff Freeman The buyer also becomes obligated to
jfreeman@idscorp.org or the ability to consider opportunities
8280 College Parkway, Suite 204
interest rate of the junior loan, particu- the regulatory requirements of the SBA- beyond either local market or portfolio
Fort
8280Myers, FL 33919
College Parkway,
larly in an environment of risingPhone: rates, (239) backedSuite
652-5588
204 loan.
junior limit considerations. The ability to table
Fort Myers, FL 33919
appeals to borrowers. Sales are largely arranged on a case-by-
Phone: (239) 652-5588 fund these loans also allows a lender to
Benefits for participating lenders in- case basis and can be either table funded avoid Regulation H issues and HVCRE
clude significant over-collateralization, or purchased after closing by the buyer. complications, given that the loan is
preservation of the borrower’s working Table funding, in this context, means that conceivably never on the books of the
capital, mitigation of interest rate risk, the purchaser, rather than the origina- originator. In this vein, some secondary-
and a lower cost structure compared to tor, directly funds the actual loan at the market buyers also have the capacity
an SBA 7(a) loan because of the limited closing table. to fund the junior portion of the debt
regulatory requirements. The small business borrower can be of- structure, until the takeout by the CDC/
fered an extensive variety of possible rate SBA-backed debenture.
Secondary-Market Enhancements structures and amortizations for the first- The benefits to revenue recognition
The bifurcated credit extensions and col- position loan, given the limited regulato- issues are equally impressive. The sale
lateral positions, in the existing regula- ry impositions on its structure. Base rates of a 504 first-position loan in the second-
tory context, create the opportunity for a most commonly offered are Libor swap ary market is structured as a whole loan
On Previous Page: Shutterstock.com

secondary market and define the possible
offerings. The junior loan, backed by the
SBA and managed by the CDC, is the fixed
assumption for the credit structure. It will
adhere to very clear requirements with a
fully amortizing 10- or 20-year term, a
and the Wall Street Journal prime rate.
However, other choices do exist. Fixed-
rate offerings across these base rates cover
virtually any time frame, from quarterly
adjustable to 25-year fixed. Likewise,
a variety of amortizations are available
sale on a nonrecourse basis with servicing
released. As such, the loans can be sold
for premiums that can be accounted for
as immediate gains under GAAP, because
the transaction is accounted for as a sale,
not as a secured borrowing—unlike with

18 The RMA Journal May 2017 | Copyright 2017 by RMA

TABLE 2: PRICING EXAMPLE FOR A 504 LOAN SALE*

Basic 504 Structure $1,000,000 acquisition of building &

equipment, with eligible installation/closing costs

First-Position Loan $500,000 50% Five-Year Fixed @ 5.1%

Second-Position Loan $400,000 40% ulated. Execution risk exists, as in any

Borrower Equity $100,000
504 Secondary Market
Eligible Loan $500,000
Five
Markup to Par Pricing 0.75%
Premium 3%
Prepayment Structure Declining 7%, 6, 5,4,3,2,1
Premium 0.75%
Net Lender Origination 0%
Originating Lender
Premium & Fees
*December 2016
the SBA 7(a) program.3 These premiums
are commonly in the range of 1% to 4%
of the face value.
Additionally, origination fees can be
retained by the lender, assuming that the
payment of the SBA third-party lender
participation fee is accounted for in the
transfer.4
The gain realized by the lender, 3.75%
(Table 2), does not compare to the levels
achievable in the 7(a) program’s secondary
market. Nor does it carry the significant
costs of origination and compliance essen-
tial to preserving the SBA guarantee under
7(a). The impact is no less significant in
ROE considerations: There is no remain-
der asset on the balance sheet and thus no
accounting complications as implied in
ASC Topic 860: Transfers and Servicing.5
Pricing a 504 secondary-market loan
sale is a balancing act between provid-
ing a marketable offer to a borrower and
maximizing the originating lender’s gain
on the sale from premium and retained
10%
1/2 of 1% charged to
borrower on first-position
permanent loan
3.7500%
fees. The critical drivers to the premium
are the spread to the par rate and the
prepayment structure.
Par rates are the base above which final
borrower pricing earns a premium, usu-
ally at a rate of 1% for every incremental
0.25% in the borrower rate. In today’s
low-rate environment, up-pricing a rate
may be difficult, owing to competition or
borrower perceptions. The prepayment
structure offers a way to offset this, as
it commonly includes an allowance for
a prepayment of up to 20% of the out-
standing balance without incurring any
costs. Thus, a borrower can commit to
a substantial prepayment structure, ef-
fectively as a pricing inducement to the
originating lender, with limited financial
implications.
The participants in the 504 secondary
market are a diverse group ranging from
nationally chartered banks to closed-
end fund. In the time since the Great
Recession, the market has been re-pop-
participated credit extension. However, as
SBA regulations allow taking additional
collateral during the interim loan period,
collateral positions can be conditionally
constructed to mitigate this risk.6
Execution risk also needs to be con-
sidered in the overall 504 credit-approval
process, which involves multiple parties
(originating lender, secondary-market
buyer, the CDC, and the SBA itself) and
can become unwieldy. The best way for
any originating lender to manage this risk
is to know the CDC involved, as CDCs are
effectively the gatekeepers to the entire
process. CDC licenses can be readily dif-
ferentiated by two measures: accredited
loan program (ALP) status and abridged
submission method (ASM) status.
ALP status is a measure of long-term
commitment and overall SBA regulatory
compliance. ASM is a more medium-term
measure of SBA confidence in the CDC’s
capability, allowing for a reduced level of
application documentation required by
SBA for the approval process. Accord-
ingly, the two measures should be taken
as a whole.
Conclusion
The 504 program offers a risk-mitigated
way to offer a highly customized credit
structure to a small business. Given that
the structure carries significant benefits
to the small business concern, it offers
lenders an approach with a high likeli-
hood of both internal credit approval and
market acceptance.
The SBA 504 product, with selective
use of the secondary market, also offers
a cost-effective alternative to large-scale
SBA 7(a) operations with fewer compli-
ance and financial reporting complica-
tions. Any lender making an extension
of credit must keep its borrower’s needs
and long-term financial health in mind
since these are critical to the repayment
of the loan.

May 2017 The RMA Journal 19

TABLE 3: CHART AND STATISTICAL DATA FROM SEPTEMBER 2006 TO JANUARY 2017 co-founder and one of two portfolio managers for
The 504 Fund, a closed-end mutual fund that makes
DEBENTURE RATE 10 YEAR T-NOTE SPREAD OVER T-NOTE a market in SBA 504 first-lien loans sold by banks,
credit unions, and nonbank lenders. He can be
JAN. 2017 2.82% 2.38% 0.44% reached at jblanchard@504fa.com.

MEAN 3.66% 2.86% 0.80% Notes

MEDIAN 3.24%
STDEV 0.012522692
The low and long-term fixed rates of
the 504 program and the preservation
of working capital, when customized
to a borrower, clearly serve any small
business well—and lead to growth. And
growing small businesses create jobs and
economic opportunity in a local com-
munity. And as an old banking adage
2.65% 0.62%
0.009626853 0.005569379
reminds us, the surest and soundest way
to grow your lending institution is to
grow your community.
Thomas Wallace is president of IDS Corporation, a
CDC. He currently serves on the board of directors
of both NAGGL and NADCO. He can be reached
at twallace@idscorp.org. Jordan Blanchard is a
1. See Third Party Lender Agreement, SBA Form 2287.
2. Regulatory requirements for structuring these first-
position loans amount to a minimum term of either
seven or 10 years and a reasonable interest rate, the
latter defined as “6% over the New York Prime Rate.”
See 13 CFR 120.921: Terms of Third-Party Loans.
3. ASC 860 constitutes the principal guidance on the
transfer of a portion of an entire financial asset for
sales accounting.
4. According to 13 CFR 120.972, this is “a one-time fee
equal to 50 basis points on the Third Party Lender’s
participation”—namely, the permanent loan in first
position.
5. See note 3.
6. See Third Party Lender Agreement, SBA Form 2287,
Terms and Conditions, Section 6.

20 The RMA Journal May 2017 | Copyright 2017 by RMA