As Americans, we are glued to the latest CNN, Fox, or local news reporting the developments in Washington as to bail-out programs. If you are a small business owner, you are waiting for your bailout–some good news about freeing up capital markets so you can apply for a modest small business loan. Amidst this dismal news, you might be tempted to ask: “Can you hear me? Is there anyone out there still making business loans? There are such lenders, but they are getting fewer by the day.
To understand the problem, you have to get a grasp on how SBA lenders operate. In the days of our parents and grandparents, banks would make a loan based upon their liquidity stemming from bank deposits. They kept the loans in house and collected the interest. You did not have to stay awake in accounting class to figure out one can only make a limited number of loans–the amount of interest you are collecting is small in relationship to the total principal loaned. You might make a $100,000 loan, but only get $10,000 back during the year on interest. At a certain point you simply run out of money to loan.
But that all changed in the last several decades when banks were able to immediately sell their loans on the secondary market and get cash. So the same $100,000 loan could immediately be sold for, hypothetically, $110,000 (the increased value or premium comes from the fact that the purchaser would receive interest over the term of loan well in excess of the principal loaned) and the bank would get fresh monies back into their coffers. So they re-tooled, fired up the machines, and started cranking out more and more loans. The more they sold on the secondary market, the more profit and further loans could be made.
SBA loans were particularly attractive. Investors drooled over those babies. The Federal government guarantees them from default at the rate of between 50% and 90%, depending upon the program utilized. So the banks would pool together and package their loans, selling on the secondary market. Whoopee! In turn, investors would buy them almost like a security. It was a win–win situation for everyone. For this reason, the secondary market was very robust for such loans.
But there was a downside. SBA loans are based upon a floor percentage (4.5% for Community Express loans with ten year terms) plus the Wall Street Journal prime rate. So, for example, the current prime rate is 3.25% and when added to the floor percentage yields a total percentage of 7.5%. But the prime rate keeps going down. As such, interest becomes lower and lower and therefore less attractive to investors (“less spread”).
And worse yet, the number of SBA loans is decreasing. For example, in August and September of 2008, SBA loans were down approximately 50% from the year before.
As a result, the secondary market has dried up. According to James Hughes, President and CEO of Unity Bancorp, there’s virtually no market left for SBA loans. See Pullback in Secondary Market Hits SBA Lenders (October 30, 2008). This means that the larger banks are using exclusively depositor’s monies and corporate debt to process their loans.
So what is a small business to do? Here are some suggestions:
o Choose a SBA licensed lender that is not a large bank. Remember, banks are the traditional institutions that have checking and savings accounts, credit cards, CD’s and the like. In this market, few if any of them are making small business loans. On the other hand, non-depository SBA lenders are much more likely to loan.
o Find a lender that has had many years of experience with small business loans. They are much more likely to be small business friendly.
o Choose a lender that does nothing but SBA small business loans. Since this is their only way of making money, they have no choice but to continue loaning, even in a bad market.
The good news is that Congress will hopefully renew the discussion of invigorating the secondary market to encourage small business loans. I’m not saying this as a wide eyed idealist, but from the simple reason that capital channels cannot be plugged up indefinitely in our country. Even our politicians can’t mess up that simple fact of capitalism. When this happens, the money will again flow. I firmly believe this will happen, it is only a question of when. In the next article I will discuss what financial institutions might still be making business loans.