The Paycheck Protection Program (PPP) is a key portion of the CARES Act and meant to provide relief for small business impacted by COVID-19. Administered by the Small Business Administration through the 7(a) program, lenders will be able to provide unsecured loans to small business, as defined, with a 100% guarantee by the SBA.
Initial program specifications were announced by the US Department of the Treasury on March 31, 2020, with updates made on April 2, 2020. Additional guidance may be announced in the future. On April 6, 2020, the Federal Reserve announced its intention to create a facility to facilitate lending under the PPP, though no other details were made available.
For lenders, the PPP loans present complex business decisions, many of which may be influenced by additional program details and secondary market reactions in the coming days. Below, we address important questions lenders should address when considering and navigating the PPP option.
Should I participate in the PPP?
There are many factors to consider. For many institutions, traditional loan pipeline volume has shrunk dramatically, with traditional credit standards tightening and uncertainty over short- and medium-term economic activity.
Originating PPP loans could be an ideal way to keep existing lending personnel productive and generating income via SBA processing fees.
Existing SBA-certified lenders have delegated authority to process PPP loans, which should reduce additional administrative burdens or costs to participate in the program.
While all federally insured depository institutions and credit unions are eligible to participate, they’ll need to be enrolled with the SBA. This requires an application, and will incur additional time and costs to complete and maintain the SBA status.
Loan Oversight and Support
Historically, SBA loan programs have been a specialized area that institutions needed to appropriately staff and monitor for compliance with programs.
The PPP program requires the borrower to support the amounts forgiven under the loan, and the lender or servicer will be required to work with the borrower to ensure the support is sufficient, which will increase the administrative burden of these loans.
Lenders are encouraged to be cautious of the increased risks of participating in other non-PPP SBA programs without the appropriate personnel and lending processes.
How would my existing borrowers benefit from the PPP?
Community lending institutions tend to loan to small businesses and real estate owners in their communities, which are among the businesses most impacted by COVID-19.
While there may be some challenges with investing in the origination infrastructure or the hassle of becoming an SBA-approved lender, as referenced above, participating in the PPP could be a key tool in maintaining the credit quality of a lender’s existing portfolio.
Supporting a Borrower’s Customers
Consider a commercial real estate loan to a small developer with eight ground level retail units, occupied by fully-functioning small businesses that are now dramatically impacted by COVID-19.
Lenders may be best positioned to preserve the cash flow of the real estate loan. This can be done by extending PPP loans to the small businesses occupying the borrower’s retail units, of which rent payments are specifically included as an approved purpose and ultimately forgivable under the program terms.
The program intends to provide cash to pay payroll costs and rent, with benefits to the small business, its employees, property owners, and their lenders.
Similar benefits from extending PPP loans to existing borrowers could occur for loans secured by accounts receivable or other business assets.
Further, providing PPP loans can help demonstrate the institution’s commitment to work with borrowers and help strengthen lending relationships.
Should I sell or hold a portfolio of PPP loans?
Traditionally, loans made under the SBA’s 7(a) program allow the originating lender to sell the guaranteed portion into the secondary market, usually at a substantial premium.
It’s currently unknown how strong the secondary market, if any, will be for PPP loans, which carry a much lower interest rate than normal 7(a) loans, potentially requiring the PPP loan to be sold into the secondary market at a discount to par. The terms of the Federal Reserve program likely will influence whether a secondary market or other source of liquidity develops for these loans.
Secondary Market Expectations
While there are many unknowns given the early stages of the program, understanding the market expectations for the duration of the loans will greatly impact any discount required by the market.
In the current ultra-low, short-term rate environment, if investors expect the duration of the loans to be relatively short, for example six months, they may accept a small discount to par. This could be credited to a combination of the interest rate environment and the relative credit risk, with a one-year Treasury rate of 0.15%, as of March 31, 2020, and the PPP loans being backed by the full faith and credit of the US government.
However, if the market prices the PPP loans at the two-year contractual maturity, the required discount will likely be higher.
Given the market uncertainties in selling a PPP loan, lenders may wish to look harder at retaining the PPP loans on the balance sheet. While the interest rate may not be the most appealing, the processing fee paid to the lender by the SBA would be treated as deferred fee, which would increase the yield of the loan through maturity.
In addition, the program appears accommodating to nontaxable loan forgiveness. While the contractual maturity is stated at two years, loan forgiveness terms are generous and structured to happen relatively quickly.
For example, the loan should be 100% forgivable assuming the borrower uses the PPP loan proceeds for the specified purposes within eight weeks of the loan’s disbursement, and doesn’t reduce employee headcount or wages beyond specified levels.
Lenders will be in a position to make the determination of forgiveness within 60 days of the borrower’s request, and presumably collect from the SBA thereafter. While the SBA hasn’t stated how quickly they’ll reimburse the lender, it’s reasonable to believe the duration of many PPP loans will be nine months or less.
Funding Sources and Loan Retention
Lenders who keep the PPP loans on their balance sheets will want to consider funding sources, and how much duration risk they’re willing to assume to maximize returns on PPP loans.
Federal Home Loan Bank (FHLB) fixed-rate advances are well below the effective yield on the PPP loans at a one-year duration, though institutions will have to determine if the interest rate spread is sufficient, particularly with no historical information to base estimates on the expected life of the PPP loans.
An added benefit of the program for financial institutions that retain the loans is that the loans carry a capital risk weighting of 0%.
What accounting factors should I consider?
Lenders who decide to sell PPP loans into the secondary market will have to consider whether or not to elect the fair value option.
Holding the loans at fair value would allow earlier recognition of the SBA processing fee paid to the lender into income. However, under the fair value option, a lender would have to recognize unrealized gains and losses on the PPP loan in current earnings.
A lender would also be required to recognize any market discount to par which the market may require on PPP loans originated for sale applying lower of cost or market (LOCOM) accounting.
Loan Origination Costs
For loans of which the fair value option isn’t elected, loan costs, including both fees paid to agents and direct loan origination costs, will be recorded as loan origination costs. These costs will be netted against the processing fee paid by the SBA and deferred over the contractual maturity of the loan, if originated for the portfolio, or until sold if originated for sale.
Given the simplistic nature of the application, direct loan origination costs would likely be much smaller than a traditional SBA loan.
In addition, given the expected pipeline of these PPP loans and the uncertain economic benefits to lenders, it’s unlikely lenders would want to incur the cost of using an agent to source PPP loans.
We’re Here to Help
To learn more about the PPP program, contact your Moss Adams professional.
Note on COVID-19
During this unparalleled time, we’re closely monitoring the COVID-19 situation as it evolves so we can provide up-to-date guidance and support to help you combat uncertainty. For regulatory updates, strategies to help cope with subsequent risk, and possible steps to bolster your workforce and organization, please see the following resources: