I never met him, but we spoke on the phone and he had more damning things to say. He said BLX focused on issuing as many loans as it could, as fast as it could, so that it took severe shortcuts in underwriting loans. According to him, BLX management consciously de-emphasized underwriting by installing underwriters with “no lending experience.” BLX did not properly check a borrower’s creditworthiness or collateral. Most notably, BLX did not verify that each borrower had invested equity in the business (called an “equity injection”), which is a basic SBA lending requirement to ensure that the borrower had “skin in the game.” As a result of all this, BLX experienced increased loan defaults.
The former employee said BLX developed the reputation for selling shoddy loans that went into early default. He said BLX used accounting assumptions on these loans “that were crazy” because they relied on outdated historical information on the average life of its loans that failed to account for the more sophisticated nature of today’s borrowers, who are more likely to refinance with cheaper capital when it becomes available. As a result, he said the company’s average-life assumptions were way too long. No wonder Allied took great pains to keep the gain-on-sale assumptions from public review. Even when Allied provided voluntary supplemental disclosure about BLX, it never revealed the gain-on-sale assumptions.
The former employee told us to look into the questionable background of Matthew McGee, the head of BLX’s top-producing office in Richmond, Virginia. In short order, we found that McGee was convicted of felony securities fraud in 1996 and spent a few months in prison. Apparently, as an employee of Signet Bank, he siphoned money from institutional customers into his family’s account. The SEC banned him from ever again working in, or affiliating with, an investment company.
His father, Robert, had been a vice president of Allied Capital in 1992 and later became a senior executive of BLC Financial. BLC Financial hired Matthew McGee after he got out of prison, while he was still serving two years of supervised release. According to the former employee, Matthew McGee sat on BLX’s credit committee. This would have violated the terms of the SBA’s waiver to BLC Financial to permit McGee’s employment after his release from prison. Moreover, the former employee told us BLX honored Matthew McGee at a recent corporate summit and held him up as an example to its other loan officers, asking, “Why can’t everybody be as productive as McGee?”
When Jesse Eisinger from The Wall Street Journal confronted Allied about McGee’s role, it denied McGee was on the committee. However, additional former BLX employees have also told us that McGee was, in fact, a voting member of the credit committee.
BLX had a lot to gain from pushing these substandard loans. Gain-on-sale accounting enabled the company to recognize its income at the time the loans were originated. The more loans BLX made, the more earnings it reported. Churning out loans was good for its bottom line and good for its executives’ bonuses. Not only that, but taxpayers bore most of the risk because the federal government guaranteed three-quarters of each loan against loss. This sort of arrangement can promote reckless behavior by unscrupulous operators like BLX.
BLX split the SBA loans into a government-backed guaranteed piece and an unguaranteed piece, which retains credit risk. Historically, BLX sold the guaranteed piece to banks at a 10 percent premium and retained an annual servicing fee of about 1 percent for collecting payments and working out problems. The premium reflected the value of the spread between the interest rate on the loan, generally the prime rate plus 2.75 percent—the maximum rate allowed in the program—less the servicing fee and the risk-free rate. BLX pooled the unguaranteed pieces and securitized them. This front-loaded income and meant that BLX only had exposure to the junior residual, which it retained.
Sweeney would explain how it worked in the next quarterly conference call: “If you originate a million dollars [sic] SBA 7(a) loan, you immediately sell $750,000 of that loan into the secondary market. Those are paying cash premiums today of ten percent. You get $75,000 of cash right on that sale. You then only have [$250,000] left in the loan . . . and you sell that via securitization, . . . but you sell off of that $250,000, $245,000 and you get cash back through a securitization. So, out of that million-dollar loan, you only end up with [$5,000] of equity capital required to capitalize it. So, [$5,000] in and your first year cash proceeds are the $75,000 gain on sale. You get $7,500 on your servicing fees that you get on that loan that you sold. And, you get $9,800 in interest on the [$245,000] piece sold for a first year . . . revenue of $92,000. So on a $5,000 investment, you get $92,000 of cash in the first year.”
Banks that purchased the guaranteed pieces of these loans were taking a hit on the 10 percent premiums they paid BLX. When a loan defaults, the government guarantee reimburses the owner the face amount of the guaranteed piece. However, the owner loses any premium it paid for the loan. As a result, though the SBA (which doesn’t track defaults efficiently) didn’t notice the rising default rate, the banks did, and became hesitant to pay a 10 percent premium. As a result, BLX had to accept a lower premium to sell the loans.
In response, BLX restructured its sales so BLX retained the early default risk by selling the guaranteed piece without any premium and keeping a larger servicing spread. This change reduced BLX’s cash flow because it no longer received cash premiums up front. Instead, BLX booked more non-cash revenue through gain-on-sale accounting, recognizing its estimate of the future value of the larger servicing spread it retained.
The former employee also gave us the names of representatives at financial institutions that purchased loans from BLX. We contacted
