Know Your Premium Before You Underwrite Your Next SBA Loan

SBA Lending

There is an argument to be made that a bank should underwrite every 7(a) SBA loan that comes its way. With a 75% guarantee and an average 10% premium net of cost and operational risk, that imputes a 30% cumulative probability of default. That is, as long as the bank thinks that there is a 70% chance of repayment, the bank should make that loan. This leaves a whole lot of room for error. Even if you underwrote nothing but one of the riskiest of major sectors, restaurant franchises, you would still be OK as their historic cumulative default rate is approximately 28%.

 

Of course, you could do better than that, even with very little underwriting. If you just stayed away from 20 of the top 500 risky restaurant franchisers (anything with “wings” in the title, pizza places no one’s ever heard of, Philly cheesesteak places, etc.) and excluded a limited number of key industries such as tanning parlors, shellfish farmers, video rental, anything that competes with Dollar Tree or cellular resellers and almost any other loan you make would statistically give you about a 14% cumulative default rate.

 

You could do even better and include all the above, but just focus on making sure that each borrower has a six year track record and has produced cash flow that would equate to current 1.25x debt service coverage. Cash flow level and volatility are the two factors that overwhelm almost everything else, including loan-to-value, and would produce a cumulative default rate below 6% given this current market.

 

The credit arbitrage that the 7(a) Program affords can be a gift to banks and it all starts with the premium as that has a huge influence on profit. The lower that premium, the higher the credit quality required to produce a profit. Right now, if you take the average credit quality of an SBA loan (including non-bank lenders), the breakeven works out to be approximately an 8% premium. If you think your loan is average credit quality, then you shouldn’t make that loan below an 8% premium.

 

The non-leveraged or cash-on-cash return of an SBA loan that is sold with a 13% premium is about 44% for the first year and about 5% thereafter including the extra servicing spread. Considering the average life of an SBA loan is about 3.5 years (projected to be longer given where current rates and credit spreads are), that works out to be about a 15% return on capital for an average loan’s life – one of the best deals in banking.

 

Our point today is not that banks should take any SBA 7(a) loan that comes their way, only that they should consider the premium when underwriting. The key to SBA profitability is to have a great servicing and packaging department to reduce your operational/legal risk while originating loans with above average premiums and below average probability of defaults. Banks that do this well, and keep their costs low can produce a consistent 30% ROE with modest leverage.