TO:                 All XYZ Captial, Inc. Employees

 

FROM:           John Doe

                        Jane Smith

 

DATE:            August 3, 1999

 

Re:                  Securitization Decision

 

 

As many of you know, XYZ decided to forgo securitization for 1999 for many reasons. The purpose of this communication is to give you some background on the issue that led to the decision, and discuss the implications for our business.

 

The SBA had been working on new rules for any 7(a) originator who uses securitization to sell its unguaranteed 7(a) loans in the secondary market. According to the SBA, these measures were necessary to protect the safety and soundness of the 7(a) lending program by ensuring that the lenders retained an "economic interest" in the loans which were being sold through securitization.

 

Originally, the proposed rules contained three restrictive requirements: 1) a minimum capital requirement, 2) a subordinated certificate requirement and 3) a delinquency test. Throughout a long comment process, which included public hearings, the three requirements changed, but in the end, the basic three restrictions remained in place. However, the third item, called the "Currency Rate" became more restrictive in the final regulations (published Feb 1999) than the original proposal. Although we were not too concerned about the first two restrictions, the Currency Rate calculation, if broken, could jeopardize the company's PLP status. This restriction does not apply to lenders who don't securitize (after the rule was effective), but once a lender securitizes, the currency rate calculation is set and the lender is held to the benchmark indefinitely.

 

To summarize, we evaluated various pros and cons and came up with the following:

 

Pros

 

·        Short term profitability, particularly 1999 and 2000

 

Cons

 

·        Potential PLP Probation & Suspension

·        Volatility of our historical Currency Rate compared to the SBA threshhold

·        Short-term versus longer term profitability (if no securitization)

·        Undue management focus on maintaining the Currency Rate versus running the business

·        Uncertainty regarding TSBC recent delinquency trends (due to benchmark measurement of  initial currency rate)

·        Unfavorable market conditions anticipated for the remainder of 1999, which would have resulted in less than optimal execution (rates and spread) of a securitization

 

The decision was not reached without some agony due to the significant impact on 1999 and 2000 profitability versus the risk of losing our PLP status. In the end, the risk of losing PLP status outweighed the profitability issue from our parent company perspective.

 

It is evident there will be a renewed focus within our company to achieve profitability in year 2000. This is a very big challenge, since in recent years, many SBLC's have not achieved significant profitability without securitization. In addition, the secondary market premium erosion of 30%-40% creates an additional hurdle.

 

In the short-term, particularly in 1999, we will report operating losses. As you know, we have begun our Process Improvement Project and will be rolling out changes to our loan origination process in order to gain efficiencies and improve quality and customer service. Improving efficiencies and reducing our cost of originating a loan will be one of the most important ways to return to profitability in 2000. We will need 100% effort and "buy-in" to our new process in order to achieve our objective which is to become the "best", not necessarily the largest, 7(a) originator.

 

This decision has long-lasting implications. Although we will always keep our options open and will lobby the SBA for rule modifications, we don't expect to securitize in the near future. That means we have the potential to "grow" our balance sheet and build up our serviced loan portfolio at a faster rate, resulting in increased servicing income. In addition, we will evaluate opportunities to purchase loan portfolios from other lenders as a strategy to build the balance sheet faster. We will evaluate new product opportunities, but not before our loan origination process is more efficient and running smoothly. Our business is one of economies of scale, and the larger the loan portfolio, the more we cover our fixed costs and reduce our "cost of origination". Then, as we add loan volume, we also add profits.

 

 

One development in the political arena that many of you may know about:  Proposed legislation has been approved in a conference committee to 1) increase the 7(a) guaranty maximum to $1,000,000 from $750,000, 2) cap the maximum 7(a) loan at $2,000,000 and 3) institute mandatory prepayment penalties for 7(a) loans. Although we don't know if these proposed rule changes will become law, it is encouraging to see these proposals. We welcome all three of these proposals, particularly the prepayment penalties.

 

In conclusion, we believe that the decision reflects XYZ's commitment to the long-term success of the 7(a) lending business, and sends the message that we will figure out how to return to profitability as quickly as possible, making our company the envy of the 7(a) lending arena.