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Small-business borrowing may get more expensive.
Randy Myers, CFO Magazine
November 1, 2004
For an Administration that likes to trumpet the "ownership" society, it's a bit perplexing: President Bush wants to eliminate the federal subsidies that support the nation's smallest businesses. The U.S. Small Business Administration's most popular loan program, the 7(a) Loan Guaranty Program, accounts for 40 percent of all long-term loans to the country's 25 million small businesses. In general, that universe encompasses companies with no more than 500 employees and maximum annual revenues, depending upon the industry in which they operate, of anywhere from $750,000 to $28.5 million. These companies serve as an important engine of growth — President Bush himself credits small businesses with creating two-thirds of the new private-sector jobs in this country, employing more than half of all workers, and accounting for more than half of the nation's economic output. Yet start-ups and other small businesses often lack the experience or equity that lenders require before they'll provide them with conventional long-term financing.
The proposed change is the subject of heated debate between the SBA and the lenders that actually make the loans. SBA administrator Hector Barreto describes the gambit as a way to save taxpayers money and free the program from dependency on the sometimes-disruptive congressional appropriation process. He has a point: this past January, for example, the program was temporarily shut down after it ran out of funding authority following Congress's failure to pass a fiscal 2004 budget by the end of fiscal 2003.
Barreto's critics argue that a self-funding program will require higher user fees, making loans unaffordable for some borrowers and potentially driving some lenders out of the program. They also question whether 7(a) would actually be more stable outside the appropriation process. Chris Lehnes, vice president of business development at CIT Small Business Lending, notes that even though the SBA's smaller 504 real estate and capital equipment lending program is self-funding, "there are still battles every year over fees and how much that program can fund."
This latest brouhaha comes at a time when the SBA is approving 7(a) loans at a record pace. It took the agency just over 10 months in the fiscal year ended September 30, 2004, to guarantee more loans — 67,493 — than it had in all of fiscal 2003. With fiscal 2004 winding down, the SBA was on pace to guarantee loans worth a total of $12.7 billion, versus $8.8 billion in fiscal 2003. The maximum loan amount is $2 million.
Lenders and Borrowers Both Benefit
The 7(a) program is popular with owners of small businesses because it allows them to put less equity into deals than conventional bank loans would require, and because it offers longer payback terms and access to financing for higher-risk ventures, such as fast-food restaurants and other small retail operations.
Lenders like the program because it helps them leverage their capital. The SBA guarantees 50 percent to 85 percent of the typical 7(a) loan, and lenders can sell the guaranteed portion in a thriving secondary market, which lets them write more loans than would otherwise be permitted.
Historically, the SBA has relied on three principal funding sources to make good on 7(a) loans that default: loan-guaranty fees, which are assessed on lenders but are typically passed directly to borrowers; loan-servicing fees assessed on lenders, which can't be passed directly to borrowers but are taken into account by lenders when setting interest rates on their loans; and federal subsidies. Should losses exceed the funds available from those sources, taxpayers are on the hook for the difference, beyond the federal subsidy, though an SBA spokesman says that's never happened. In fact, he says, the default rate on 7(a) loans is only slightly higher than the default rate on comparable conventional loans. Meanwhile, the program boasts some notable success stories: Callaway Golf Co., Intel Corp., and Outback Steakhouse Inc. are all former borrowers.
In fiscal 2002, Congress initiated a program of fee reductions as part of its effort to jump-start the economy. For fiscal 2004, Congress granted subsidies totaling $101.2 million to the 7(a) program, which gave the SBA authority to guarantee loans totaling at least $12.5 billion. For fiscal 2005, the SBA contends that it can support the same amount of lending without any subsidies, as long as Congress doesn't extend the fee-reduction program. The program expired in early October, and the loan-guaranty fee on the smallest 7(a) loans — those totaling less than $150,000 — doubled, to 2 percent. Loans of $150,001 to $700,000 reverted back to 3 percent from 2.5 percent. For loans above $700,000, the fee remains at 3.5 percent. Meanwhile, the annual loan-servicing fee the SBA charges lenders bumped back up to 50 basis points.
The SBA argues that the impact on small business of allowing its guaranty fees to revert to their prefiscal 2002 levels will be negligible — less than $10 a month for most borrowers over the life of the loan. Of course, many borrowers are required to cover those fees at closing, which for borrowers of larger loans could mean coughing up a couple of thousand dollars more to get their financing. While that might sound like a rounding error to larger companies, it can be significant to firms with five- or six-figure revenues.
Craig Lindgren, president and owner of Boulder Exhibits Inc., a St. Louis-based designer and builder of trade-show exhibits that does about $1 million a year in sales, says he would have been troubled by the prospect of paying higher fees on the 7(a) loan he took out in September. He borrowed $820,000 for 25 years to finance the purchase of a 23,000-square-foot office and warehouse. Although he'd qualified for a conventional bank loan, he says the SBA package allowed him to put less equity into the deal — just 10 percent — and conserve more of his working capital. Higher fees, he said, "would have deterred us from going with the 7(a) loan and would have made us look at other options."
For some borrowers, of course, even higher guaranty fees would not offset the benefits of a 7(a) loan. Pattie and Wes Skaperdas, owners of manufacturing company Phipps & Bird Inc. in Richmond, Virginia, took out a 7(a) loan in May to retire existing debt, fund the purchase of a new computer system and plastic molds, and expand the firm's powder-coating operations. The "$600,000-plus" borrowing, says Wes Skaperdas, has a 10-year term and a floating rate of prime plus 2.75 percent. Higher fees, he says, probably would not have scared his firm, which generates about $2 million in revenue annually, away from the SBA. "First of all, we didn't have too many options," he explains. "We had been talking to other lenders for about two years, and were turned down by just about everybody. While an increase in fees would have been a burden, my cash flow has improved so dramatically from doing this that it would have easily absorbed any fee increases."
Beginning of the End?
To some critics of the Administration's proposal to eliminate federal subsidies, the worry is not just that some borrowers might be priced out of the market, but that the proposal might signal the beginning of the end for the 7(a) program. They point to recent history to support their suspicions. Tony Wilkinson, president and CEO of the National Association of Government Guaranteed Lenders (NAGGL), notes that President Bush's proposed fiscal 2004 budget called for giving the 7(a) program only $9.3 billion in lending authority that year, even though the program was, at the time the budget was unveiled, already doing $1 billion of business per month.
Congress ultimately authorized $9.5 billion, but with funds being parceled out under a continuing resolution on a quarterly basis, the 7(a) program ran out of money before the end of its first fiscal quarter. That prompted the SBA to lower its maximum loan amounts and even shut the program down for several days. It marked the fifth time in 10 years that the SBA cut the program's maximum loan size below the statutory limit of $2 million. "The Administration really put us in a bind," says Wilkinson. Congress ultimately appropriated additional subsidies that gave the program another $3 billion in lending power and allowed it to remove the tighter loan caps. Still, says Wilkinson, "We think we missed $500 million to $1 billion in loan demand."
NAGGL members — banks and other SBA-approved lenders — also lack confidence in the formula being used by the Office of Management and Budget to set loan loss reserves for the 7(a) loan portfolio. Historically, the OMB overestimated the potential for loan defaults, says Wilkinson, to the extent that from fiscal 1995 through fiscal 2003, the 7(a) program returned $1.2 billion in unused subsidies and excess user fees to the Treasury. The OMB adopted a new reserve formula in fiscal 2003, but Wilkinson says he'd like to see it tested against real-world conditions for several more years before dramatic changes are made to the 7(a) program. If the formula turns out to be flawed and yields insufficient reserves, or if business conditions prompt default rates to skyrocket, loan fees for an unsubsidized 7(a) program would have to be jacked up dramatically in a self-funding environment. "If your default rate doubled and fees had to double, you would have no place to go," frets Wilkinson. "Once you're off the appropriation cycle, good luck getting back on."
Randy Myers is a contributing editor of CFO.