Bottlenecks, Red Tape, High Costs Hinder SBA Loan Programs

President Obama’s plans to aid small businesses by providing banks with low-cost capital to make more loans has been criticized for its trickle-down approach to putting capital into the pockets of entrepreneurs.

The president’s program has also put a greater emphasis on leveraging the Small Business Administration’s loan programs to help boost lending. But many of those programs are hampered by bottlenecks, red tape, and high costs, which are compounding the problems caused by stingy banks.

Ryan P. Fochler, owner and president of Dog Paws ’n Cat Claws Pet Care, in Arlington, Va., knows well that giving banks more money to lend doesn’t mean it will reach small, growing companies that need it most.

In December 2007, his company was preapproved for a SBA 7(a) loan, which is the SBA’s flagship loan program.

The loan was made through Provident Bank, and allowed Fochler to expand his business by opening a store. “Within two months, our retail store was experiencing both commercial success [and] we have even received national recognition as a ‘green’ retail establishment,” he told the House Small Business Committee during a recent hearing.

“Unfortunately, shortly thereafter, the credit crisis hit in full force,” he said in his recent testimony. “To be specific, despite having never made a delinquent payment, our lines of credit went from $56,000 to less than $1,000 without warning. I felt sick to my stomach; we had grown from seven employees to 20 at that point,” he recounted.

Despite a credit score of 720, and a 168 percent growth rate for his business over the first three years, the move touched off a cascade of problems that made it even harder to borrow money.

“This severe and, in my opinion, unwarranted reduction in credit made it nearly impossible for us to reorder new product for our retail store,” he explained. “It also created a horrible domino effect; the drastic lowering of our credit lines resulted in a much higher debt-to-available-credit ratio for our business.

“Now, instead of using about 50 percent of our available credit, we were at 90 percent, which made us look like a much riskier bet to banks and other credit card companies. My credit has since taken a nosedive,” he added.

When he went to his bank, he heard a refrain that is likely all too familiar to small business owners in the current downturn. His bank told him: “You have been a good customer up until now, but there is no guarantee that you will be so in the future.”

Fochler, who was forced to close his store and lay off employees, puts a human face on the credit crisis and helps explain why the number of loans guaranteed through SBA programs fell by 40 percent during FY 2009. Even with SBA guarantees, banks are still reluctant to loan money.

Such Catch-22 situations have also hamstrung the SBA’s key 504 loan program, which provides capital to purchase fixed assets, such as real estate. The program is considered one of the SBA’s most successful. Since its creation in 1986, it has been credited with creating more than 2 million jobs.

But during the downturn, when the loans have been needed the most, the SBA has been ratcheting up the cost of the program. The FY 2010 SBA budget raises the cost for small businesses to participate in the program by 38.9 basis points per year, and an even bigger increase is likely in FY 2011.

“For the average 504 borrower, this represents an increased interest cost of almost $50,000 for the life of their loan. For FY 2011, this figure may far more than double,” said Zola Finch, who testified on behalf of the National Association of Development Companies, an organization which represents 504 program lenders. “These fee increases will clearly negate the benefits of the stimulus bill.”

The Catch-22 occurs because the program is “zero subsidy,” which means it must pay for itself. Because the SBA is projecting that loan defaults will increase from 3.5 percent for FY 2009 to more than 7.3 percent for FY 2010, fees must increase to cover the projected costs of the defaults.

“The ‘credit box’ has become much tighter, and only the strongest small businesses are now qualifying for new loans,” said Finch, whose organization believes the SBA is overestimating the default rate.

In 1997, the SBA also grossly overestimated the cost of defaults, costing thousands of small businesses millions of dollars in inflated guarantee fees, Finch said. Almost 20,000 small businesses will be hit by the latest fee increases.

Small Business Investment Companies, or SBICs, have been caught in a similar bind. SBICs are private equity funds set up to invest exclusively in small emerging companies.

The Debenture SBIC Program has been one of the SBA’s most successful loan programs, and has provided critical startup funding for hundreds of companies including Intel, Callaway Golf, Outback Steakhouse, PeopleSoft, Staples, and Quiznos. But if the next Intel were to apply today, the story might be different.

Despite the success of the program, only about 20 percent of the SBA’s $3 billion in lending capacity was utilized in FY 2009, denying domestic small businesses more than $2 billion in SBA leverage and $1 billion in private growth capital, according to Carolyn Galiette, who spoke on behalf of the National Association of Small Business Investment Companies.

Like the 504 program, the Debenture program is zero subsidy, and its costs are increasing as well. But the top complaint about the SBIC program is SBA red tape. “The SBA often takes over a year to issue an SBIC license, even for successful SBICs that are seeking their second, third, or fourth license,” Galiette said.

In FY 2008, only six licenses were issued -- more than a 90 percent decline from the peak of the 1990s, Galiette said. The SBA did somewhat better in FY 2009, when 11 licenses were issued. But scores of quality funds, many repeat SBICs, are still trying to get an SBIC license, she said.

The recession has also highlighted other Catch-22 restrictions. Once an SBIC grows to a certain size, for example, it is pushed out of the program; in effect, it’s punished for its success. The programs also place limits on contributions to funds by state and local governments.

These cases are just some of the examples of the bottlenecks and red tape hampering SBA loan programs. While Obama should be commended for leveraging the SBA as part of his effort to increase small business lending, throwing money at banks won’t solve the problem without a comprehensive overhaul of the SBA’s loan programs.

Fortunately, legislation has been sponsored in Congress to address some of these problems, but those efforts need to be coordinated and fast-tracked to make efficient use of the stimulus funds the administration has earmarked for small firms.