There are three ways to grow a profitable loan portfolio. One isby originating loans within your field of membership, or throughthe CUSOs you belong to. Another is to purchase participationloans. And the third is to purchase government guaranteed loans.Here is some information that can help you succeed with methods twoand three.

• Like participation purchase, individual, government guaranteedloans go on your loan portfolio along with participations.
• Like most participation purchases, these loans are serviced foryou. You get a monthly statement and an ACH transfer orcheck.
• Unlike participations, the part you buy with an SBA or USDAguarantee is guaranteed as to principal and accrued interest,irrevocably, by a corporation of the U.S. government. Thus, unlikeparticipation loans, guarantees have no (zero) principal risk andzero accrued interest risk. They are repurchased, at par, by theSBA or USDA or other agency in event of default. The servicer dealswith the borrower – and with the SBA and USDA.
• Guaranteed loans trade at a substantial premium and hence carrythe risk that they might pay off before you have amortized thepremium. Clearly, premium risk is a lot less than risking defaulton an entire loan – but it is a loan selection risk you can largelyprotect yourself against by reviewing the underlying loan againstthe default rates published for each and every businessclassification – data the SBA has been collecting for nineyears.

If a loan defaults or prepays early any unamortized premium willhave to be immediately amortized.

The breakeven point is the point at which your cash flow aftercost of funds exceeds the premium you paid for the loan. Forexample, if you pay a 6% premium for the guarantee and the netcoupon is 4.6%, and your cost of funds for three months is about 60basis points, your breakeven point is:

4.60% Net Coupon after Servicing (adjusts every threemonths with no caps)
-.60% Cost of Funds
=4.00% Effective

BEP = 6.00% / 4.00% = 1.5 years

So, if the loan stays 1.5 or more years, you are ahead of thegame and there's not a cash loss for an early prepayment. Moreover,on USDA credits, you (the investor) get to keep the prepaymentpenalty, which is often quite substantial, in event of a voluntarypayoff. On SBA deals, the SBA keeps the penalty.

The most popular and widely traded government guaranteed loansare SBA 7A guaranteed loans (individual loans and pools) and USDAguaranteed loans.

The maximum SBA 7A loan is $5 million. Loanscan now be guaranteed to a maximum amount of 75% of the outstandingprincipal, so the maximum guarantee is $3.75 million. Theoriginating lender keeps the non-guaranteed portion and servicesthe loan. .

Most SBA 7A loans adjust monthly or quarterly. Some are fixedfor three to five years, or for the term. These are called“orphans” as they are not included in pools, which are pass-throughsecurities. They all pay monthly. Most have a high cap on the rateor no cap at all.

Typically, the USDA guarantee is fullyamortized over a term of up to 25 years. Terms are shorter if thecollateral is equipment. The rate may be fixed for one to 10 years,then adjust quarterly over Prime or LIBOR, or adjust every three orfive years. Or, the loan may adjust monthly or quarterly from thevery start of the term.

Government guaranteed loans are rated as a low-risk assetbecause the secondary (as opposed to primary) market guaranteecannot be taken away. “This is an unconditional guarantee to theinvestor or registered holder regardless of the actions of theoriginating lender,” writes the SBA's counsel in commenting on51 Comp.Gen 474, interpreting Section 5 of the SmallBusiness Act, known as 15 USC 634.

In sum, USDA and SBA guarantees are an asset class unique forcredit unions – they grow the loan portfolio, but in other respectsare treated as securities. They carry substantial premium risk – arisk which can be understood and analyzed during the loan selectionprocess. They yield much less than participation loans, but farmore than agencies. And for many credit unions, they are a handyway to grow outstandings without principal risk.

Tim Thomas is vice president of lending at the $76million Credit Unionof the Rockies in Golden, Colo.