Politically Correct Lending

When loans are made for political considerations as opposed to financial ones, capital is wasted and we are all made poorer

by DOUGLAS FRENCH

There seems to be only one kind of loan that bankers want to make—SBA loans. SBA stands for Small Business Administration, a federal agency that guarantees certain loans made by banks that operate within its guidelines.

Lawmakers portray SBA lending as a boost for small businesses. The program is actually a form of corporate welfare for some of America’s largest banks. While banks reap profits, taxpayers cover the losses.

SBA lending is especially lucrative because, with a government guarantee, there are plenty of buyers for these loans in the secondary market. Borrowers are paying interest rates of 6 percent or more and the government is standing behind the majority of the loan balance. Buyers will pay large premiums for that kind of risk-free yield.

As hard as it has been to pry funds from lenders since the financial crash, the SBA had record years in 2011 and 2012, writing over $30 billion in loans each year. Making a profit and collecting interest and principal are not included in the SBA’s goals. Instead, the agency’s three strategic initiatives for 2012 were as follows:

1. Growing businesses and creating jobs.

2. Building an SBA that meets the needs of today’s and tomorrow’s small businesses.

3. Serving as a voice for small businesses.

The agency’s flagship loan product is the 7(a) program that funds business loans. More than $15 billion in SBA 7(a) loans was disbursed in 2010. The two years following were brisk as well, nearly matching the boom years of ‘04 through ‘07. These loans were used, per SBA guidelines, “to establish a new business or to assist in the operation, acquisition, or expansion of an existing business.” 

Why, in particular, was there a surge in 7(a) loans?  The Congressional Research Service reports,

Congressional interest in the 7(a) program has increased in recent years because of concerns that small businesses might be prevented from accessing sufficient capital to enable them to assist in the economic recovery. Some, including President Obama, argue that the SBA should be provided additional resources to assist small businesses in acquiring capital necessary to start, continue, or expand operations with the expectation that in so doing small businesses will create jobs.

Somehow, people like those cited above have come to believe that small businesses are at a disadvantage in obtaining credit. It’s a “market failure,” if you will. So the Small Business Act of 1953 created the 7(a) loan guarantee wherein 85 percent of a loan’s principal up to $150,000 is guaranteed by the government; the guarantee drops to 75 percent for loans more than $150,000. During 2010 and 2011, the guarantee was bumped to 90 percent.

Reams of paperwork are required of loan applicants, and of course approval can sometimes take months. First the bank does its investigation, and then the SBA does it all over again, unless the banker is an SBA preferred lender—then the agency will guarantee whatever loans the preferred lender makes, providing they followed the guidelines. Despite all of this rigorous underwriting, the SBA program has cost taxpayers $1.3 billion since 2000, according to an investigation by the Dayton Daily News. The paper found that a number of borrowers defaulted on their first payment. “Operators of national franchises like Quiznos and Cold Stone Creamery collectively received millions of dollars in loans through the program despite extensive default histories by the franchises,” write Lynn Hulsey and Ken McCall.

One would think there is always a market for sandwiches and ice cream. It turns out nearly 2,600 loans were taken out to fund Quiznos locations from 1990 to 2012, almost half as many as for Subway sandwich shops. According to Hulsey and McCall, these franchises dominated the list of businesses using government guaranteed financing. The 4.8 percent default rate for Subways is considered high. Quiznos’ rate is 23.4 percent.

“Quiznos also led all franchises with $43.5 million in defaulted loan guarantees that SBA had to pay the lending banks. Cold Stone Creamery was second with $29.6 million, followed by Days Inn with $16.9 million and Ramada Inn with $14.3 million.” Evidently being a part of a household name franchise and benefiting from national advertising does not ensure success. It’s worth wondering just how careful the underwriting was on those loans.

Pat Newcomb, director of the Ohio Small Business Development Center at the Entrepreneur Center in Dayton, Ohio, told the Dayton Daily, “There were an awful lot of people who got small business loans during this period 2004 to 2007 that shouldn’t have gotten them.”

Default rates soared after the 2008 financial crash. Lenders in a free market might pull in their horns in the wake of such bad loan experiences. Lenders handing out 7(a) funds, however, had a banner year in 2012, after their guarantee rates were increased in 2010 and 2011.

SBA lending is based upon politics and quotas, not economics. For instance, Bloomberg Businessweek reports that the national leader in 7(a) loans, Wells Fargo, has set a goal of lending $5 billion to Asian-American business owners by the end of this year. “KeyBank also runs a minority and women's business enterprise program to help boost those outfits.” The SBA’s website has dozens of minority lending, training, and grant programs listed. With Congress and the President behind small business lending and taxpayers footing the bill, government-backed lending has been full speed ahead while credit is tight otherwise. Why should the banks do anything else? 

This all should remind readers of the mortgage business. Through entities like Fannie Mae, Freddie Mac, and the FHA, the government now controls more than 90 percent of the home mortgage market.

The small-business Coyote Blog explains,

The SBA has already pretty much killed small business cash flow lending. Basically, if you want a loan secured only by cash flow, the SBA is your only choice. Why would a bank make such a loan privately when they can make it and get an SBA guarantee paid for by the client? As a result, no bank even has a desk for non-SBA lending, and since SBA lending is hard, many don't have an SBA desk any more.

The blogger for Coyote speculates that the SBA has killed innovation in the private lending market and writes, “loans with SBA backing have crowded out everything else out there, such that a small business really can't find a lender who will make small business loans except with SBA backing. Bankers are people too, and they can get lazy. They have come to rely on these government programs.”

Commenters on the blog confirmed the writer’s view:

·         “Banks simply don't understand anything other than SBA guidelines.” 

·         “The amount of cluelessness seen was pretty breathtaking. Basically, bankers (in general) know just enough about SBA guidelines to be able to semi-randomly throw stuff against the wall and see what sticks. Actual business knowledge? I couldn't find any.” 

·         “I have no doubt the SBA killed off development of new ideas on small business lending.”

The SBA and the banks have PR machines that highlight the successful businesses that started with SBA financing. Like all government programs, there are always a few very visible beneficiaries. What isn’t so apparent is that when loans are made for political considerations as opposed to financial ones, capital is wasted and we are all made poorer.