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Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, October 7, 1993.

I am here today to discuss the Federal Reserve Board's views on the Business, Commercial, and Community Development Secondary Market Development Act (H.R.2600). The objective of this legislation is to promote economic growth and credit formation by facilitating the development of a secondary market for business, commercial, and community development debt and equity investments in the private sector. The Federal Reserve shares this important objective. Many businesses, particularly smaller businesses, have been encountering difficulties in obtaining credit. Moreover, there is a well-recognized need for community development financing.

Securitization can confer benefits to financial organizations as well as the credit customers they serve, as we have seen in other sectors of the credit markets in which securitization of bank-generated loans is common. While borrowers in these sectors have benefited from an increased availability of credit, banking organizations and other financial institutions have been able to improve their liquidity and diversification of risk. This experience suggests that similar salubrious benefits could result from the development of a secondary market that would encourage the securitization of loans to businesses and community development projects. In this regard, the Federal Reserve favors the approach of H.R.2600 of promoting securitization in these sectors by relying on the private sector rather than by creating a new governmental program that would extend an explicit full faith and credit U.S. government guarantee to achieve that end.

The bill's objective of providing additional sources of credit to the business community is, we believe, particularly important as it pertains to smaller businesses. Over the past two decades, such businesses have become increasingly important to the U.S. economy. Most of the recent gains in employment are largely attributable to industries that are dominated by smaller businesses, such as retailing. In the aggregate, the volume of business activity generated by small and medium-sized firms accounts for approximately one-half of the employment and receipts in the nonfinancial, nonfarm business sector. Clearly, the prospect for the future growth and prosperity of our economy is closely tied to the health and vigor of smaller businesses.

The bill's objective of enhancing the availability of financial resources to community development enterprises is also of great importance. These enterprises support projects - such as improving the stock of affordable housing and providing financing to minority-owned businesses - that are crucial to the economic advancement of disadvantaged urban areas and distressed rural communities.

An important factor in the success of smaller firms and community development projects is their ability to acquire adequate credit accommodation. Historically, the commercial banking system has been the primary source of financing to smaller businesses, which have few funding alternatives. Community development programs also tend to rely on commercial banks for financing.

As is well known, however, many smaller businesses and community development enterprises have encountered difficulty in obtaining financing from depository institutions in recent years. These institutions, having experienced substantial loan-quality problems - which stemmed from nearly a decade of aggressive lending often on terms more liberal than warranted by the credit standing of their borrowers - significantly tightened their lending standards in the late 1980s and early years of this decade. Recently, with improving asset quality and profitability, banks appear ready to begin increasing lending activity, as indicated by our surveys. This development should benefit the small business sector and community development programs. Nonetheless, given the importance of smaller businesses and community development enterprises to the well-being of our country, innovations that can appropriately increase their access to financial resources would be most welcome.

I should note here that to promote greater availability of credit, the Federal Reserve and the other bank supervisory agencies have recently implemented several initiatives designed to ensure that regulatory practices, or perceptions of regulatory procedures, do not impede lending by banking institutions. Some of these initiatives were designed particularly to benefit smaller business borrowers and low-income and minority neighborhoods, possibly through community development programs.

One such initiative was 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. Another important initiative is the agencies' proposal to increase from $100,000 to $250,000 the threshold amount below which real estate-related loans - including loans to businesses that are collateralized by property - do not require appraisals under Title XI of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.

In addition, an interagency letter was issued giving guidance on fair lending. The letter stressed the serious nature of violations of antidiscrimination laws and included guidance on the steps that financial institutions can take to ensure compliance with relevant fair lending statutes and regulations.

Given the importance of ensuring an adequate flow of financial resources to businesses and community development enterprises, new means for promoting that end should be sought, and, as H.R.2600 points out, securitization might serve that purpose. Banks and other financial institutions have been active in the securitization of other types of loans, such as mortgages, and it is possible that they could also be active in the pooling and securitizing of business and community development loans. This activity is altogether appropriate for banking organizations if it is done in a manner consistent with safe and sound banking practices.

Asset securitization consists of placing loans into a pool and issuing securities that entitle the holders to the proceeds of the principal and interest payments flowing from the underlying loans. Bank lenders that engage in securitization can benefit from improved liquidity, enhanced fee income, and - if a true sale has occurred resulting in the removal of the assets from their balance sheets - less need for capital. On the other hand, investors are able to purchase securities that require no management of the underlying loans and provide an attractive return for instruments that bear little or no credit risk, depending upon the nature of the credit enhancement.

Thus, securitized assets can offer improved diversification and a greater selection of risk and return alternatives. Purchases of asset-backed securities may be valuable to smaller banks that do not have the capability of diversifying their portfolio geographically or according to industrial sector.

The impressive growth in the residential mortgage-backed securities market and in the markets for securities based on auto loans and other consumer loans has dramatically demonstrated the benefits that securitization has to offer. In view of these benefits, the Federal Reserve believes that it is important to give significant thought to all proposals designed to promote this activity and expand it to other types of assets such as loans to businesses and community development enterprises.

Nonetheless, it should be recognized that the nature of business and community development loans differs significantly from the types of loans - such as residential mortgages and credit card receivables - that are now being securitized. Although these latter types of loans are relatively homogeneous, business and community development loans tend to be quite heterogeneous in nature, in part because of the differences among the enterprises themselves. Moreover, the terms of such loans tend to differ widely because they are most often individually negotiated to suit each borrower's unique credit needs. As a result, these types of loans have a wide range of maturities and repayment terms, different degrees of documentation, and disparate amounts of information regarding the underlying financial conditions of the obligors. The high degree of heterogeneity among these loans greatly complicites the ability to predict future cash flows that will be produced by pools of even the highest credit quality.

Pools of business and community development loans often also exhibit diversity with regard to credit quality, which, coupled with diversity in documentation standards, greatly complicates the task of performing due diligence and reaching a judgment on the overall quality of the pool. Finally, the lack of a historical database on business loan performance that is sufficiently broad and deep makes actuarial methods of estimating loan losses extremely difficult.

Furthermore, community development loans may manifest even more heterogeneity. These loans are often quite large, entail extensions of credit to several borrowers with different credit standings, and exhibit complicated structures that may include public and private sector involvement on several different levels. For example, a single loan to a program for the revitalization of several properties within a particular neighborhood could involve several borrowers having varying degrees of experience and financial capacity and be supported by numerous state, federal, and private assistance programs.

The heterogeneity of business and community development loans not only represents a hurdle to their successful widespread securitization but also causes securities markets to require substantial credit enhancements on pools of such loans. At the same time, the special nature of business and community development loans makes it relatively difficult for banks to accurately assess the riskiness of issuing such credit enhancements. On the other hand, underwriting such loans to have similar maturities, repayment schedules, and yield could make them more homogeneous and, thus, could facilitate their securitization. However, these types of loans are often specifically tailored to meet the unique needs of each borrower.

A standardized loan product would introduce inflexibility into the business lending process and could preclude banks from extending credit to certain firms and organizations because they do not fit the "mold." In addition, the standardization of business and community development loans could increase the amount of documentation needed to obtain such loans. In this regard, it should be noted that since the advent of securitization of residential mortgages, mortgage lenders have tended to require significantly more documentation to facilitate the sale of mortgages into the secondary market. It is possible that rigid and inflexible underwriting standards and increased documentation requirements could actually curtail the amount of available credit for businesses and for community development.

Given the amount of innovation in the securitization market over the past several years, we do not believe that the hurdles to securitizing business and community development loans are insurmountable. As I mentioned earlier, this activity may be appropriate for banking organizations if it is conducted in a safe and sound banking manner. In our view, one of these safeguards would require that adequate capital be maintained against participating organizations' risk exposure. In this regard, the banking agencies are currently drafting proposals that are aimed at revising the capital treatment of recourse arrangements, which we believe, when finalized, should reduce any obstacles in our current capital rules that may be hindering the securitization of business and community development loans.

Turning to the provisions of H.R.2600, I would reiterate that the reliance on the private sector is the preferable approach. However, we have concerns about certain aspects of the legislation. We believe that it would create a new regulatory structure for secondary market facilitating organizations, or SMFOs. These institutions would be certified by the Treasury Department, which would also establish capital standards and loss reserve requirements, promulgate minimum operating standards and reporting requirements, and arrange for regulatory examinations. These are traditional regulatory and supervisory functions, but under the legislation none of them would be carried out by the agencies currently responsible for the regulation and supervision of insured depository institutions and consolidated banking organizations.

Thus, we believe that, with respect to financial institutions that already are regulated by a federal government agency such as the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision, this legislation would create a parallel regulatory structure that duplicates the work of those agencies. As we have discussed with committee staff members, the Federal Reserve will continue to work with the committee to address these issues.

As the Congress continues to consider ways to facilitate securitization of business and community development loans, we believe that the preferable approach would be to fashion legislation directing the primary federal regulatory agencies to develop appropriate standards. This legislation would enable the agencies to address the securitization of such loans in a manner that would be consistent with the prudential framework for securitization more generally. We believe that such an approach is more likely to promote economic efficiency and bank safety and soundness. It also would avoid the rigidities that result when technical and complex regulatory requirements are written into law. The agencies need flexibility to be able to adjust the rules to later experience in the market.

As I said earlier, we support the overall objectives of H.R.2600. The bill places a reliance on the private sector to develop the secondary market for business, commercial, and community development loans, and we find that aspect of the bill attractive. It is imperative that in attempting to facilitate the securitization of these types of loans we avoid creating another government agency or increasing government liabilities by extending additional government guarantees.
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Title Annotation:Statements to the Congress
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Dec 1, 1993
Previous Article:Minutes of the Federal Open Market Committee Meeting of August 17, 1993.
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