Statement by John P. LaWare - Statements to the Congress - Board of Governors, Federal Reserve System - securitization of small business loans - Transcript

Federal Reserve Bulletin, August, 1994

I am here today to discuss title II of the Community Development, Credit Enhancement, and Regulatory Improvement Act of 1994 (H.R. 3474), entitled Small Business Capital Formation, as passed by the Senate on March 17, 1994. Title II seeks to increase the availability of credit to small businesses by facilitating the securitization of small business loans. The objective of this bill is extremely important, particularly given the problems that some small businesses have had in obtaining adequate credit accommodation. Moreover, experience in other sectors of the credit markets where securitization has become widespread suggests that securitization of small business loans could confer benefits on banks and other financial institutions that originate, securitize, and invest in these loans.

Accordingly, the Federal Reserve supports the objectives of title II. We believe that its implementation may prove helpful in encouraging the development, through the securitization process, of a secondary market for small business loans. We also support the bill's approach of promoting this development by relying on the private sector rather than involving the government through yet another guarantee program.

Small- and medium-sized businesses have always been of critical importance to the U.S. economy. They have served as an engine for job creation and as a major source of innovation in product development. To continue to fulfill these roles these businesses must have the ability to obtain adequate credit accommodation. Traditionally, the commercial banking system has been the principal source of credit to smaller businesses, and the small business segment has contributed importantly to the earnings of the banking industry.

Unfortunately, during the latter part of the past decade, and in the first year of this decade, as banks encountered severe problems in their loan portfolios, they generally tightened their lending standards. As a result, the availability of credit was significantly reduced, particularly to small businesses. With its markedly improved performance in the past two years, the banking system has been able to strengthen its balance sheet and is in a much better position to lend to small businesses and other borrowers. Government agencies have also taken a number of steps to encourage banks to loan to small businesses, including a program to allow banks to establish a "basket" of loans that will be judged on the basis of performance and not be criticized on the basis of documentation deficiencies. Taking these developments into account along with the generally improving economy, it is not surprising that the volume of small business loans has been growing since last fall.

Nonetheless, there may be many situations in which creditworthy small businesses are continuing to encounter difficulties in obtaining credit. Besides addressing the problem created by the credit crunch of recent years, it is highly desirable to find ways to promote, in an efficient but prudential manner, the flow of credit to smaller businesses.

A possible way to maintain or increase small businesses' access to credit could be the expansion of opportunities to securitize small business loans. Although the approach is no panacea, it has been given increased consideration in recent years.

In a securitization, loans are placed in a pool and securities are issued that entitle the holders to the proceeds of the principal and interest payments flowing from the underlying loans. Originators of loans that are used in asset-backed securities could benefit from improved liquidity, enhanced fee income, and--to the extent that a true sale has occurred and the assets are removed from their balance sheets--less need for capital. Investors, on the other hand, acquire securities that require no management of the underlying loans on their part and yet provide an attractive return for instruments that pose, depending upon the nature of the credit enhancement, little or no credit risk.

For the securitization of assets to be successful, the resulting security must be appealing to investors, who are generally risk averse. When evaluating securities, investors rely heavily on the national credit-rating agencies to inform them of the credit risk associated with securities through the assigned credit ratings. Thus, securitized transactions must have sufficient credit enhancement to obtain a credit-rating level that makes the securities attractive to investors.

Both sales and purchases of securitized pools offer improved diversification and a greater selection of risk and return alternatives. Purchases of securities backed by loans may be particularly valuable to smaller banks that do not have the capability of diversifying their lending either geographically or according to industrial sector.

Given the potential benefits to be gained from the securitization of small business loans and business loans generally, the Federal Reserve believes that it is important to give careful consideration to proposals designed to promote and encourage the securitization of such loans. These potential benefits have been dramatically demonstrated by the impressive growth in the residential mortgage-backed securities market and the markets for securities based on auto loans and other consumer loans. It thus seems reasonable that small business lending could also benefit from securitization.