Last week, the U.S. Small Business Administration shut down its 7(a) loan program again, leaving thousands of small business owners scrambling to finance a wide range of business projects. This shutdown (the fourth since I've been in small business lending) was swiftly overturned, as Congress approved an increase in the 7(a) program cap to $23.5 billion for the remainder of this current fiscal year. That's $4.75 billion more than the current ceiling that had effectively been hit, necessitating the shutdown. President Obama quickly signed the bill into law. Crisis averted. Or is it?
More than 11 years ago, I first commented on this matter in the Wall Street Journal, and it was the first time the public had been led behind the curtain of SBA lending. The fundamental problems still exist today and led us right into this current silly shutdown.
The 7(a) loan program has a wide-range of proceeds that their loans can be used for: business acquisitions, partner buyouts, working capital, debt consolidation, startup capital, equipment financing, and real estate financing. In my lending career, I've made many 7(a) loans for each of these types of proceeds. However, it is estimated that more than 30% of the total amount of 7(a) loans each year are made only for owner-occupied commercial real estate transactions. We wouldn't have this, or any prior SBA tarnishing shutdowns if 7(a) loans were only used for non-real estate proceeds. Because while the 7(a) program is currently choked, billions of dollars in lending authority funds, which could easily pick up that slack, go unused every year for one of the SBA's other lending programs known as the 504 loan program. By changing what can and can't get financed with each SBA loan program, there would more than enough dollars remaining in both programs -- and really no need to put another $4.75 billion of taxpayer guarantees at possible risk.
Why doesn't this happen? For that answer, we have to pull back the curtains a bit more and reveal what's really happening in the SBA industry. It involves greed, deception and maybe even some "predatory" lending behavior.
I realize that calling some behaviors "predatory" will raise some hackles, but what else would you call a virtually systemic practice of convincing small business owners to accept an inferior loan program on commercial real estate transactions, which almost certainly puts these borrowers in future harm's way, only so a bank can maximize its income?
Valuable Guarantees Make Banks Rich at Borrowers Expense
7(a) loans typically have a 75% U.S. government guarantee. And these guarantees are extremely valuable. A robust secondary market pays buyers of these guaranteed loans up to 20% as premium fees for these loans. Yes, that's right, on a $1 million loan whereby $750,000 would be sold into the secondary market, the selling bank often earns up to $112,500. These are historic premiums for these loans. And now you understand why highly specialized SBA departments in well-run banks are typically the most profitable division in those banks. (The SBA wisely curtails premium payments above $100,000, requiring the selling bank to split half of the excess premiums with the agency.)
Deceptive and Possibly Predatory Behavior Follows
In order to achieve these premiums, a commercial loan officer must convince a small business owner to take a floating interest rate on their 7(a) real estate loan. The SBA limits the maximum rate charged to Prime + 2.75% (or 6% today). Not a bad rate, but we all know short term interest rates have nowhere to go but up from here, probably later this year.
But should the borrower jump online before committing to work with the bank, he or she might uncover another alternative (the 504) whereby the down payment would likely be the same as with a 7(a), the amortization would likely be the same, the fees would be slightly less, the interest rates fixed and probably lower, and the collateral needed to be pledged, much less intrusive. Which do you think they would choose?
If borrowers never learn about other options from their banker, isn't that a form of deception? Is it not predatory to push a borrower into a loan product that makes the bank more money while costing the borrower more in the long run?
504 Loans as Part of the Solution
Steering real estate loans out of the 7(a) program and into the 504 would have a variety of positive consequences. First, they are often a better product for small business owners who want to purchase real estate. SBA 504 loans have two mortgages, a first for 50% of the total project amount and a second for 40% of the total project amount. The difference is the borrower's equity or down payment contribution of 10%. The permanent second mortgage is a 100% SBA-guaranteed bond that is fixed for 20-years at a below-market interest rate. With 504 loans, borrowers pay fixed interest rates on fixed assets with longer terms. So small business owners hold on to more of their cash due to lessened interest rate risks. And these loans are almost always less onerous than other options.
The second reason is that the 504 loan program has excess lending authority which could be leveraged to take the stress off of the 7(a) program. In fact, each year billions of dollars which could be used by small business owners goes untapped. So while the 7(a) runs ragged, the 504 is healthy and in need of more customers. This would free-up more funds for 7(a) loans to provide growth capital, while allowing the 504 program to more efficiently utilize its lending authority as well.
The 7(a) program remains popular, and many of its proponents will take issue with my recommendations; but the facts remain the same as they did 11 years ago. A solution to the oft-repeating shutdown "crisis" remains right in front of us. We can fix the problem while also helping small business owners and entrepreneurs - understandably one of the most cherished segments of our economy. We all deserve better.