Small Business Administration: A Primer

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1 The Center On Federal Financial Institutions (COFFI) is a nonprofit, nonpartisan, non-ideological policy institute focused on federal lending and insurance activities. Zachary Kalman and Douglas J. Elliott June 10, 2006 sba@coffi.org Small Business Administration: A Primer The Small Business Administration (SBA) promotes growth in small business, primarily through loans, administrative and technical assistance, and advocacy on the part of the SBA. This primer focuses on the SBA s role as a credit institution. It is intended to provide a neutral explanation of the SBA s functions. COFFI does not normally take policy positions. The following questions are addressed: Basics What is the SBA, and how does it function as a credit institution? Who typically receives loans or assistance? How does the SBA provide credit? What types of assistance does the SBA provide, other than loans? SBA Loan Programs What are the main loan programs, and how do they function? What types of disaster recovery loans are provided? What special purpose loan programs are offered? Other SBA Financial Assistance Programs What is the Small Business Investment Company (SBIC) Program? What is the Surety Bond Guaranty (SBG) Program? Finances What is the current amount of the SBA s outstanding loans? What are the recent trends in lending practices? What is the potential taxpayer exposure to the SBA?

2 Finances (continued) What are the loss rates for loan programs? What interest rates apply to SBA loans? How are the costs and revenues from SBA loans reflected in the federal budget? How are lending programs financed? Current Issues What were the concerns with loan sales, and how has the SBA responded? How has the SBA responded to the Gulf Coast hurricanes? Conclusion What is the future of the SBA likely to be? Basics What is the SBA, and how does it function as a credit institution? The SBA is, principally, a source of funding for small businesses on terms more favorable to the borrower than those available through commercial lending channels. While the SBA does provide other important services, providing low-interest business loans has been its primary purpose throughout its history. Established in 1953, the SBA replaced the Reconstruction Finance Corporation (RFC). President Hoover created the RFC in 1932 as a federal lending institution intended to assist businesses hurt by the Great Depression. The Small Business Act of July 30, 1953 created the SBA with the stated function to aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns. The SBA is an executive branch agency with an Administrator appointed by the President and confirmed by the Senate. It is overseen by the House Small Business committee and the Senate Small Business and Entrepreneurship committee. Upon its creation, the SBA assumed the lending functions of the RFC, providing financial assistance to small businesses and victims of disasters. The SBA continues to supplement the private market by guaranteeing loans made by commercial lenders to small businesses, as well as by providing small direct loans to businesses that are unable to borrow in the commercial market. Additionally, the SBA acts as the primary source of direct loans from the federal government to businesses and home-owners who require funding for disaster recovery. Over time, the SBA s programs have expanded to include contract procurement assistance, management and technical assistance, specialized programs for minorities, women, and veterans, and loans and assistance dealing with international trade. 2

3 Who typically receives loans or assistance? In general, recipients of SBA loans are businesses that qualify as small according to SBA standards and would benefit from loans at advantageous terms. In some cases, these businesses lack resources or business knowledge. In these cases, the SBA often provides technical and management assistance in addition to loans. In addition, there are currently a whole host of SBA programs intended to provide funding and assistance to various specific small business interests. Among many others, these programs include: Loans to businesses owned by minorities or women Special financing for exporters Assistance to businesses negatively affected by NAFTA Help in acquiring funds to meet tightened pollution standards How does the SBA provide credit? Loans under SBA programs come in two basic forms, loan guarantees and direct loans. In the case of loan guarantees, the main form of assistance, the SBA takes on part of the risk held by commercial lenders that provide loans to qualified small businesses. The SBA agrees that, if the borrower defaults on the obligation, the government will reimburse the lender for its losses, up to the percentage guaranteed. As opposed to issuing loans directly, using the guaranty mechanism allows the SBA to share some of the risk of small business loans with private sector lenders. The amount guaranteed by the SBA varies depending on the loan program. Through the 7(a) Loan Guaranty program, the most commonly used lending channel, the SBA guarantees 75 to 85 percent of the loan amount. Loans made by certified development companies, through the 504 Loan program, are 100 percent guaranteed by the SBA. Direct loans from the SBA, without the involvement of private lenders, comprise a smaller part of the SBA s lending. These direct loans occur mainly in the SBA s micro-loan and disaster relief programs. (A more detailed explanation of loan guarantees and direct loans is given in COFFI s Budgeting for Credit Programs: A Primer which can be found at What types of assistance does the SBA provide, other than loans? While the focus of this primer is on the SBA s credit functions, it is important to note that the SBA also provides other forms of assistance to small business. The SBA has numerous programs that provide management training, informational resources, and technical assistance to developing businesses. Some of these programs include the Office of Entrepreneurial Development, the Office of Business and Community Initiatives, SCORE, and the Small Business Training Network. In addition, the SBA helps small businesses acquire preferential consideration for government contracts, through programs like the Historically Underutilized Business Zone (HUBZone) program. Detailed descriptions of these programs and others, as well as links to their individual websites, can be found at 3

4 SBA Loan Programs What are the main SBA loan programs, and how do they function? There are four basic loan programs that represent most of the SBA s lending activity. These are the Basic 7(a) Loan Guaranty program, the Certified Development Company 504 Loan program, the Micro-loan 7(m) Loan program, and the Loan Prequalification program. Knowledge of these loan programs is critical to understanding the SBA s function as a credit institution. Basic 7(a) Loan Guaranty The Basic 7(a) Loan Guaranty serves as the SBA s primary channel for providing loans to qualified small businesses. It is the SBA s most flexible loan option, allowing financing for a wide variety of business purposes. In 2005, the program originated an estimated $16 billion in loans and had a budget subsidy rate of 0.2%. In the Basic 7(a) program, loans are provided by commercial lenders and guaranteed by the SBA. These lenders structure their loans according to SBA guidelines and apply to receive guarantees on their loans, whereby the SBA assumes a share of the risk that the borrower will default on a portion or all of the loan. Since no funds are lent directly by the SBA, applicants must approach the commercial lender and meet both its and the SBA s eligibility criteria. 7(a) Loan Program o o o o o Private loans guaranteed by SBA. Maximum loan is $2 million Maximum SBA guaranty is 85% for loans less than $150,000 and 75% for loans greater than $150,000. Maturities vary based on ability to repay, purpose of the loan, and useful life of the assets financed. Maximum maturity is 25 years for real estate and 7 years for working capital. Wide range of business uses including real estate, debt refinancing and working capital. The SBA criteria for a 7(a) loan are very broad, in order to allow for loans to a wide variety of small businesses. Applicants must be for-profit enterprises without the internal resources necessary to finance their activities. They must be able to demonstrate capacity to repay the loan, and they must be considered a small business by the SBA. According to the Small Business Act, an eligible small business is one that is independently owned and not dominant in its field of operation. The SBA has very specific size standards across different industries. These standards come in the form of maximum total annual receipts and total number of employees in order to be considered a small business, as defined by the 2002 North American Industry Classification System (NAICS). Some examples of these size standards include: $750,000 in annual receipts for soy bean, wheat, and corn farming, $31 million in annual receipts for industrial building construction, 500 employees for iron mining, and 1000 employees for computer manufacturing. A comprehensive listing of all NAICS size requirements across industries can be found at 4

5 Proceeds from 7(a) loans may be used for a large range of purposes. These uses include: purchasing new land or buildings or paying for construction and/or renovation of facilities acquiring new equipment, machinery, resources, or materials long-term or short-term working capital refinancing existing debt that is structured under unreasonable terms purchasing an existing business Certified Development Company (CDC) 504 Loan Program Like the Basic 7(a) Loan Program, the CDC/504 Loan Program involves loan guarantees on the part of the SBA. However, the CDC/504 program operates somewhat differently. The program is used by the SBA to provide long-term financing for small business projects with the goal of community economic development. In 2005, the CDC/504 program originated an estimated $5 billion in loans and ran a budget subsidy of -2.4%. That is to say, it made a profit according to budget rules, excluding administrative costs. A Certified Development Company (CDC) is a non-profit corporation that works with the SBA and commercial lending institutions to help finance small businesses and encourage community development. There are approximately 270 CDCs, each working with a specific geographic area. The structure of a CDC/504 loan project is somewhat more complex than that of a 7(a) loan. Under this program, 50 percent of the cost of a small business project is covered by a loan from a private lending institution, secured with a senior lien. An additional 40 percent of the project cost is covered by a loan from a CDC, backed by a 100 percent SBA-guaranteed debenture and secured by a junior lien. A 10 percent equity contribution comes from the small business. The assets being financed are generally used as the collateral. A lien is an official claim against property or funds for payment of a debt. A senior lien is enforced before a junior lien, giving its holder first CDC/504 Loan Program right to claim property upon non-payment by the borrower. A debenture is an unsecured certificate of debt backed only by the credit of the borrower, not by any physical assets. o Loans provided by CDCs and guaranteed by SBA. o Maximum SBA debenture is $1.5 million for job creation, $2 million for public policy goal, and $4 million for small manufacturers. o o Maturity is either 10 or 20 years. Loans are intended to provide long-term, fixed-rated financing for fixed assets, such as land or buildings, not for working capital or debt refinancing. The maximum size of a CDC/504 loan is determined by the maximum SBA debenture. The SBA limits on debentures for CDC loans vary depending upon the community development goal of the project at hand. 5

6 When meeting a job creation goal, the maximum SBA debenture is $1.5 million. As a general rule, a small business must create or retain one job for every $50,000 provided by the SBA. According to the structure of CDC/504 loans, this $1.5 million represents 40 percent of the total project cost. Another 50 percent, maximum $1.875 million, comes from a private lender. The remaining 10 percent, $375,000, comes in the form of equity contributed by the small business. Thus, in this case, the maximum total funding for a CDC/504 project is $3.75 million. When meeting a public policy goal, SBA debentures may reach $2 million. The SBA approves debentures for loans that promote a number of public policy goals. These include: revitalization of business districts, expansion of exports, rural development, restructuring to meet federally mandated standards, changes due to federal budget cutbacks, and development of businesses owned by minorities, veterans, and women. When a small business is classified as a small manufacturer, the maximum SBA debenture may reach $4 million. In order for a small business to be eligible for the $4 million debenture it must fall under the SBA standards for a small manufacturer, as defined by the North American Industrial Classification System. It must also either create or retain one job for every $100,000 provided by the SBA, or improve the local economy or achieve one of the stated public policy goals. 7(m) Micro-Loan Program The SBA s Micro-Loan Program is quite different from the 7(a) and CDC/504 loan programs in that the SBA provides direct loans rather than loan guarantees. The Micro-Loan Program is intended to assist newly established or growing small businesses which lack the technical knowledge or financial resources to obtain loans in the market. The SBA makes funds available to local, community-based, non-profit lenders, which make the actual credit decisions. The loans made by these intermediaries are not guaranteed by the SBA. As the name suggests, the loans provided by intermediaries under the Micro-Loan program are small. The maximum loan allowed is $35,000 and the average loan is about $10,500. In 2004, the program originated only $23 million in loans. The maximum term for loans under the Micro-Loan program is six years. These loans are intended for small businesses and not-for-profit child care centers. The proceeds may be used for working capital or the purchase of supplies, inventory, equipment or machinery. Loans may not be used to refinance existing debt or to purchase real estate. In addition to the loan, intermediaries are required to provide business training and technical assistance to their borrowers. Prospective borrowers applying to receive these loans may be required to complete a business or technical training program, or both, before their applications are considered. The President s 2007 Budget proposes the termination of the 7(m) Program because it is excessively expensive relative to other programs. The program ran a positive subsidy of between 4% and 5% in 2002 and 2004, and over 14% in OMB suggests that the 7(a) program can serve a similar group of borrowers at a much lower cost. 6

7 Loan Prequalification Program: The Loan Prequalification Program is another channel through which the SBA guarantees loans made to small businesses. Prequalification is intended to help low income borrowers, disabled business owners, veterans, exporters, and new business owners put together viable loan applications and secure financing. Through this program, prospective borrowers are able to have their applications analyzed and, eventually, pre-approved for a guaranty by the SBA. Local intermediaries work with the applicant to ascertain that the business plan is complete and that the applicant is eligible. Once a loan package is put together, with the help of the intermediary, it is submitted to the SBA. If the application is approved, the SBA will issue a commitment letter indicating its willingness to guaranty the loan. The intermediary will then assist the prospective borrower in finding a lender that offers favorable rates and terms. The maximum guarantee for the Loan Prequalification Program is $250,000. Otherwise, all SBA policies for these loan guarantees are the same as those for the 7(a) Loan Guaranty program. What types of disaster recovery loans are provided? The bulk of the SBA s direct lending comes in the form of disaster recovery loans. The SBA originated $664 million in disaster recovery loans in 2004, with estimated totals of nearly $4 billion in 2005 and $4.5 billion in (Disaster loans in response to hurricanes Katrina and Rita are reflected in the 2006 budget.) As of 2005, the loss rate for the disaster loan program (the cumulative amount deemed unrecoverable as a percentage of total program disbursements) was 10%. This loss rate is significantly higher than those for General Business loans, 6%, and CDC/504 loans, 2%. This disparity is not surprising, given that the victims of disasters who receive these loans have often lost a great deal, and are therefore less likely to be able to repay the loan. Financing under this program comes via four different types of disaster recovery loans: Home and personal property loans Physical disaster business loans Economic injury disaster loans Military reservist economic injury disaster loans. Home and personal property loans are intended for homeowners, renters, and/or personal property owners in a declared disaster area. There are two types of loans: personal property loans and real property loans. Personal property loans can provide up to $40,000 to replace or repair any personal property lost in a disaster. Personal property is generally anything that is not considered real estate or part of the actual structure. Real property loans provide homeowners with up to $200,000 to restore their homes to predisaster condition. 7

8 Interest rates on these loans depend upon the applicant s ability to obtain credit elsewhere. If an applicant can obtain credit elsewhere, the rate is based on the cost of the money to Federal Government, with a maximum rate of 8 percent. Should an applicant not be able to obtain credit, the rate is cut in half, with a maximum of 4 percent. The term of home and personal property loans is determined on a case-by-case basis, with a maximum of 30 years. Physical disaster business loans are intended to assist businesses in declared disaster areas that have suffered physical damage as a result of the disaster. The SBA provides up to $1.5 million to help replace or restore damaged property to pre-disaster condition. Proceeds may be used to repair or replace real property, equipment, or inventory. They may also be used to make improvements to property in order to reduce damage in the event of future disasters. Interest rates depend on the applicant s ability to obtain credit elsewhere. If the applicant can obtain credit, the interest rate cannot exceed that being charged in the private market, or 8 percent, whichever is less. If the applicant cannot obtain credit, the maximum rate is 4 percent. The maximum maturity for physical disaster business loans is 30 years. Economic injury disaster loans provide financial assistance to small businesses hurt by a disaster, regardless of physical damage. Businesses that have incurred economic injury due to a disaster may use these loans to cover financial obligations that they could have met had the disaster not occurred. These loans also are capped at $1.5 million. The maximum interest rate on economic injury disaster loans is 4 percent, with a maximum term of 30 years. Military reservist economic injury disaster loans provide assistance to small businesses who incur economic injury because a vital employee was called up to active military duty in response to a declared disaster. These loans, which also are capped at $1.5 million, are intended only to provide the working capital necessary to pay financial obligations until operations return to normal. The maximum interest rate is 4 percent, with a maximum term of 30 years. What special purpose loan programs are offered? The SBA offers several specialty loan programs designed to assist specific small business areas. Each of these special purpose loan programs works within the framework of one or more of the main SBA loan programs previously mentioned. In the interest of brevity, only a short mention of each program and its purpose will be given here. More detailed descriptions, including terms of loans, eligibility, and approved uses of proceeds can be found at Export Working Capital Program (EWCP): This program is designed to provide short-term working capital to small business exporters that cannot otherwise find financing under reasonable terms. EWCP is a 7(a) loan program. International Trade Loans Program: This program provides financing to small businesses that are either expanding into export markets, or are adversely affected by import competition. Businesses use these funds to improve or expand facilities to enhance their competitive position in domestic or export markets. The International Trade Loans Program is a 7(a) loan program. 8

9 Defense Loan and Technical Assistance (DELTA) Program: The DELTA program is designed to assist small businesses that are making the transition from defense to civilian markets. Businesses generally apply when they are negatively affected by the closure of a Department of Defense (DoD) installation or the termination of a DoD program. DELTA loans may work within the 7(a) or CDC/504 structure. US Community Adjustment and Investment Program (CAIP): CAIP provides assistance to small businesses in geographic areas that have been hurt by the North American Free Trade Agreement (NAFTA). This negative impact is based on job losses and unemployment rates by county. CAIP works within the 7(a) and CDC/504 loan structures. Qualified Employee Trusts Loan Program: This program provides financial assistance to employee stock ownership plans. It is a 7(a) loan program. Pollution Control Loan Program: This program provides financing to small businesses for the planning, design, or installation of pollution control facilities. It is a 7(a) loan program. CAPLines Program: CAPLines is intended to provide small businesses with financing to meet their short-term and cyclical working capital needs. CAPLines is a broad SBA program, under which several more specific specialty programs operate. CAPLines loans follow the 7(a) loan structure. Other SBA Financial Assistance Programs What is the Small Business Investment Company (SBIC) Program? The Small Business Investment Company Program was created in 1958 in order to help bridge the gap between available venture capital and the financial needs of small businesses. SBICs are privately owned venture capital funds which are licensed and regulated by the SBA. SBICs make equity investments, through the SBIC Participating Securities program, and debt investments, through the SBIC Debentures program, in small businesses that qualify according to SBA standards. They do so using their own capital, supplemented by loans obtained under favorable terms reflecting guarantees from the SBA. In the SBIC program, the SBA does not make direct investments, nor does it target any particular industry. The SBIC program acts as a fund of funds, leaving investment decision-making to private fund managers. In order to obtain an SBIC license from the SBA, applicants must demonstrate experience managing venture capital funds, previous experience working together as a team, and an ability to work within the SBA s regulatory framework. Additionally, SBIC applicants must have secured investor commitments of $5 million for a debenture fund or $10 million for an equity fund. Once commitments and licensing are secured, an SBIC is eligible to receive up to $20 million for every $10 million of private equity. This 2:1 public to private funding ratio greatly increases potential portfolio returns for SBIC investors. The SBIC program attempts to create a symbiotic relationship between small businesses, investors, and US taxpayers. The goal is a scenario in which qualifying small businesses are able to receive needed equity capital and expert management assistance, venture capitalists are able to achieve greater returns by supplementing their investment funds with SBA guaranteed loans, and the taxpayer benefits because 9

10 principal and interest payments to the SBA, combined with tax revenue generated by successful SBIC investments, cover the yearly cost of the program. However, the Office of Management and Budget (OMB) has voiced concerns about structural flaws that are preventing the SBIC program from operating effectively. Among these concerns are: Small returns to the government relative to the size of its investments A lack of incentives for SBICs to promptly repay capital A methodology for calculating the program s cost that does not accurately capture the risk of subsidizing capital investments These concerns most likely led to OMB s decision not to support any further budgetary authority for the SBIC Participating Securities program, which has operated with a positive subsidy of at least 19% for several years. Investments will be focused in the SBIC Debentures program in the near future. What is the SBA Surety Bond Guaranty (SBG) Program? The purpose of the Surety Bond Guaranty program is to provide small and minority contractors with opportunities for which they would not normally be able to bid. A surety bond is a three-party agreement between a surety company, a contractor, and a project owner. The contractor agrees to complete a project according to the terms of a contract. In the event that the contractor is unable to fulfill the terms of the contract and defaults, the surety company assumes the responsibilities of the contractor and ensures that the project is completed. Through the SBG program, the SBA guarantees bonds made to qualifying small contractors that cannot obtain bonding through commercial channels. The SBA will guarantee bonds for contracts of up to $2 million. By assuming this risk, the SBA gives surety companies incentive to provide bonding to smaller, sometimes riskier, contractors. Small contractors achieve a strengthened ability to obtain bonding and expanded contracting opportunities. Within the SBG program, there are two channels through which surety companies can obtain guarantees for their bonds. These are the Prior Approval program and the Preferred Surety Bond (PSB) program. These two programs differ in both the procedure to obtain a guaranty and the amount guaranteed by the SBA. In the Prior Approval program, the surety company first must approve an application and agree to issue a bond with an SBA guaranty. The application package is then sent to the SBA for evaluation. If the package is approved, the SBA will issue a guaranty to the surety company for the bond, and, in turn, the surety company will issue the bond to the contractor. Contractors obtaining bonding through this program are generally small and have little experience. Because surety companies are taking on added risk by bonding these contractors, the SBA will guarantee as much as 90 percent of the losses from bonds issued to contractors that are socially or economically disadvantaged, and 80 percent of the losses from all other bonds issued through the prior approval program. 10

11 The Preferred Surety Bond program provides only 70 percent guarantees to surety companies. However, through the PSB program, surety companies do not need to submit application packages to the SBA for prior approval. Instead, the SBA gives select surety companies the authority to issue guaranteed bonds without an SBA review. These are generally larger surety companies, which the SBA hopes will make greater efforts to assist in small business development. Finances What is the current amount of the SBA s outstanding loans? As of the end of 2005, the SBA had nearly $73 billion in outstanding guaranteed loans and an additional $3.8 billion in outstanding direct loans. (See table 1) Table 1: Total Outstanding Loans Fiscal Year 2003 (Actual) 2004 (Actual) 2005 (Actual) 2006 (Estimated) 2007 (Estimated) Guaranteed Loans (in millions) Business $52,388 $57,493 $72,880 $82,670 $88,810 Percent Change 9.7% 26.8% 13.4% 7.4% Percent Guaranteed 98% 96% 95% 95% 95% Direct Loan (in millions) Disaster $2,979 $3,069 $3,618 $6,534 $6,817 Business $311 $264 $134 $134 $125 Total $3,290 $3,333 $3,752 $6,668 $6,942 Percent Change 1.3% 12.6% 77.7% 4.1% Total (in millions) Total Loans $55,678 $60,826 $76,632 $89,338 $95,752 Percent Change 9.2% 26.0% 16.6% 7.2% (Source: President s FY 2007 Budget Appendix) What are the recent trends in lending practices? We can see a trend of continued expansion of the SBA s total outstanding loans, with the greatest increase coming in 2005 (See Table 1). The $73 billion total of guaranteed loans as of 2005 is a $15 billion increase from the previous year. However, estimated increases for 2006 and 2007 are significantly smaller. With loan guarantees representing the large majority of the SBA s lending activity, trends in total SBA lending tend to mirror those in loan guaranty programs. Total outstanding direct loans, which remained below $4 billion through 2005, greatly increased to upwards of $6.7 billion in 2006, a 77.7% increase from the previous year. This direct lending increase comes from the growing number of disaster loans provided by the SBA. An increased number of severe hurricanes in recent 11

12 years prompted expanded disaster lending by the SBA, with lending in the wake of hurricanes Katrina and Rita responsible for the sharp spike in As the SBA flagship lending tool, the 7(a) loan program each year represents a majority of total SBA loans. The 7(a) program has increased lending activity from $10.6 billion in loans originated in 2003 to an estimated $17.5 billion to be originated in (See Table 2) This is not to say that increases in SBA lending are limited to the 7(a) program. CDC/504 loan originations have similarly grown from $2.1 billion in 2003 to an estimated $7.5 billion in (See Table 2) There is a stark difference between the loans originated under the SBIC Debenture program and the SBIC Participating Securities program. As of 2005, there is a sharp increase in loans originated under the Debenture program, matched by an even sharper drop off in loans under the Participating Securities program. As indicated in the President s Budget, OMB supports, for 2006, $3 billion in new guaranteed venture capital investments through the Debenture program. On the other hand, due to projected losses of over $2 billion, OMB supports no new investments through the Participating Securities program. In response to extremely active hurricane seasons in recent years, direct lending for disaster recovery has, proportionally, seen the most dramatic growth, from $533 million in 2003 to $4.6 billion in (See Table 2) The SBA, serving as the federal government s primary provider of disaster loans, has been extremely active in the recovery efforts after the Gulf Coast hurricanes. (The SBA response to these hurricanes will be discussed in more detail later in this primer.) Table 2: SBA Loan Originations 2003 (Actual) 2004 (Actual) Fiscal Year 2005 (Estimated) 2006 (Estimated) 2007 (Estimated) Loans Originated (in millions) Business Programs General Business 7(a) Guaranteed $10,641 $11,827 $16,000 $17,000 $17,500 SBIC Debentures $240 $607 $3,250 $3,000 $3,000 SBIC Participating Securities $379 $4,000 $0 $0 $0 Section 504 CDCs $2,149 $3,966 $5,000 $7,500 $7,500 Direct Micro loans $21 $23 $10 $20 n/a Disaster Recovery Programs Direct Loans $533 $664 $3,966 $4,587 $900 Total $13,963 $21,087 $28,226 $27,520 $28,900 (Source: President s FY 2007 Budget Appendix) What is the potential taxpayer exposure to the SBA? The total potential taxpayer exposure to the SBA s loan programs comprises the net value of the SBA s direct loans and the guaranteed amount of its guaranteed loans. In a worst case scenario, this is the cost to the federal government if every borrower defaulted and nothing could be recovered. The present maximum taxpayer exposure to the SBA s loan programs is approximately $73.5 billion. 12

13 What are the loss rates for loan programs? Table 3 shows the loss rates for SBA programs. The rates represent the cumulative loans charged-off by the SBA as a percent of cumulative loan disbursements in each program. Loans charged-off consists of the total cumulative principal still owed to the SBA that has been determined to be uncollectible. As mentioned earlier, the disaster loan program has a significantly higher loss rate than any of the other loan programs. Table 3: Loss Rates Loss Rate Loan Program (a), General Business Loans 6.85% 6.56% 6.15% CDC/ % 2.60% 2.43% SBIC 4.95% 4.46% 4.84% Microloan 0% 0.05% 0.11% Disaster Loans 10.21% 10.24% 10.04% (Source: SBA) What interest rates apply to SBA loans? Different interest rates apply depending on the loan program and, in some cases, the size and maturity of the loan. Table 4 contains some basic information about the interest rates of the different programs as provided by the SBA. 13

14 Table 4: Interest Rates Loan Program Interest Rate Rates are negotiable between borrower and lender and subject to SBA maximums. Maximums for fixed rate loans of: $50,000 or more- Prime plus 2.25% if maturity is <7 yrs. Prime plus 2.75% if maturity is >7 yrs. 7(a) Program $25,000-$50,000- Prime plus 3.25% if maturity is <7 yrs. Prime plus 3.75% if maturity is >7 yrs. $25,000 or less- Prime plus 4.25 % if maturity is <7 yrs. Prime plus 4.75% if maturity is >7 yrs. CDC/504 Program Microloan (Source: SBA) Variable rate loans are pegged either to the prime rate or the SBA optional peg rate. Rates are pegged to an increment above the current market rate for five and ten year U.S. Treasury issues. Rates vary depending on the intermediary and the costs to the intermediary from the U.S. Treasury. How are the costs and revenues of SBA loan programs reflected in the federal budget? Costs and revenues to the federal government from SBA loan programs are broken into two components in the budget. These are a subsidy cost and annual administrative expenses. Subsidies are calculated by forecasting future cash flows from loans and discounting these amounts back to today s dollars. Doing so allows for an understanding of the net cost to the government over the life of a loan, as opposed to accounting for a loan on an annual cash flow basis. This estimated net cost over the life of a loan, denominated in today s dollars, is called the net present value. The net present value differs from the total expected nominal cash flows. A given amount of money is worth more today than the same amount some time in the future, mainly due to the ability to accrue interest over time. The net present value takes account of this difference. More detailed information concerning accounting for federal credit programs can be found in COFFI s Budgeting for Credit Programs: A Primer, which can be found at A deficit for a loan program registers as a positive subsidy, while a surplus registers as a negative subsidy. Because the net present value relies upon default rate estimates and discount rates that vary from year to year, re-estimation of subsidies is necessary. The most current comprehensive subsidy data comes from 2004, while much of the subsidy figures for SBA programs in 2005 have yet to be recalculated (See Table 5). 14

15 Table 5: Subsidy Rates Fiscal Year Subsidy Rates in % Business Loan Programs General Business 7(a) -0.26% 0.83% 0.83% 0.19% SBIC Debentures 4.94% 2.15% 1.66% 2.15% SBIC Participating Securities 25.47% 21.72% 19.15% N/A Section 504 CDCs -1.95% -2.54% -2.62% -2.37% Microloan 4.47% 14.17% 4.40% N/A Disaster Loan Programs Direct Loans 24.42% 17.56% 20.29% N/A (Source: President s FY 2007 Budget) Annual administrative expenses are calculated separately from subsidy amounts and are on a cash basis. In 2004, Congress appropriated $128 million for administrative costs of business loans and $114 million for disaster loans. How are lending programs financed? Fees and interest payments on guaranteed and direct loans are not enough to finance the loan programs, so Congress annually appropriates money for the SBA. This consists of discretionary appropriations for administrative and subsidy costs and mandatory appropriations to cover re-estimations of subsidies. Since subsidy re-estimations are quite variable, appropriations to the SBA can change sharply over time. According to the President s 2007 Budget, total outlays for the SBA were $2.5 billion in OMB estimates significant decreases in total outlays for 2006 and Current Issues What were the concerns with loan sales, and how has the SBA responded? A January 2003 Government Accountability Office (GAO) report addressed concerns about five SBA loan sales that occurred from August 1999 to January The sales consisted of a total of $4.4 billion, with approximately 85% in disaster relief loans and 15% in regular business loans. The intent of the SBA Asset Sales program was to help manage the SBA s overall credit exposure, while taking advantage of private sector efficiencies and reducing some of the SBA s resource demand from loan servicing. The GAO study found that the SBA incorrectly accounted for losses on the loan sales and lacked reliable data needed to calculate the financial impact of the sales. The report also stated that, due to a lack of SBA analysis of the effect the loans sales would have on the rest of its portfolio, re-estimates of loan program costs for the budget may have been inaccurate. The main discrepancy came in the accounting for the sales of the disaster relief loans. Because these loans are offered at below-market interest rates, a subsidy allowance is appropriated to cover the expected losses. 15

16 The GAO found large, unexplained declines in the subsidy allowance between 1998 and 2001, to the point where the program was actually expected to generate a profit. In these years, the subsidy allowance declined from $1.2 billion to negative $77 million. This decline of over 100% far exceeded the 42% decline in the outstanding loan balance owed by borrowers in the disaster loan program during the time of the loan sales. An April 2005 follow-up study by the GAO investigated the SBA response to the accounting discrepancies detailed in the initial report. The study found that the SBA took prompt action in reviewing its financial records and identifying discrepancies in its accounting for disaster loans and loan sales. The SBA review yielded several findings: The agency was using an unreliable cash flow model that underestimated the cost of the disaster loan program. The model used to analyze the benefit of loan sales skewed the data to indicate that the sales were sold at gains. Incorrect loan values used to calculate the results of loan sales led to inaccurate reporting on financial statements. Incomplete tools provided by OMB to calculate interest payments on borrowing from the Treasury resulted in an insufficient balance in the SBA s financing account and subsidy allowance. It is important to note that the issues raised in the review were problems at the time of the loan sales, not today. In fact, GAO reports that the SBA has since taken action to correct these issues. The SBA has developed a new cash flow model to estimate the costs and values of loans in the disaster loan program. The SBA has improved its policies and procedures to avoid unreasonable estimates of loan program costs in the future. Using the new cash flow model, the SBA estimated its prior disaster loan sales to have resulted in losses of over $900 million. Additionally, the SBA analyzed its interest payments on borrowing from the Treasury, finding that it overpaid by approximately $134 million. The two GAO reports referred to here are titled Small Business Administration: Accounting Anomalies and Limited Operational Data Make Results of Loan Sales Uncertain (January 2003) and SBA Disaster Loan Program: Accounting Anomalies Resolved but Additional Steps Would Improve Long-Term Reliability of Cost Estimates (April 2005). These reports can be found at How has the SBA responded to the Gulf Coast hurricanes? The federal response to hurricanes Katrina and Rita has been the subject of a great deal of scrutiny and debate in the months following the disasters. As the federal government s primary provider of home and business disaster recovery loans, the SBA has played a major role in the relief efforts in the Gulf Coast region. While much of the relief effort and the surrounding debate remains to play out, it is worth discussing the SBA s activity in the region so far. 16

17 Through May 15, 2006, the SBA had approved over $2 billion in disaster loans to businesses and homeowners in the Gulf Coast region and had processed 96% of the total applications. In the process of this massive relief effort, the SBA has had to take on hundreds of loan processors and inspectors, expanding its staff from 880 to 4,000 workers. The large majority of approved SBA disaster loans have been for homeowners. Of the $2 billion total, nearly $1.7 billion has gone to homeowners, with over $300 million going to businesses. This large portion of the SBA s lending going toward homeowners is due to the volume of homeowners applying for loans. Homeowners comprise 87 percent of the 337,000 loan applications the SBA has received. Much of the concern surrounding the Gulf Coast recovery effort has come from delays in processing loans and getting the money to hurricane victims. According to the GAO, as of February 25, 2006, the SBA faced a backlog of 103,000 loan applications yet to be processed, and the average processing time was 94 days. By March 25, 2006, the backlog of applications was 55,000 and processing time was 88 days, far longer than the SBA s goal of 7 to 21 days. The GAO is currently assessing the factors that have led to the SBA s inability to provide timely assistance to the victims of the Gulf Coast hurricanes. The initial GAO analysis has indicated several factors, including: An unprecedented high volume of loan applications Outages and slow response times in the SBA s new loan processing system Inadequate planning for a disaster of this magnitude Conclusion What should SBA s role be in the future? There are several schools of thought concerning the proper credit role of the SBA. Many observers believe SBA should have the same basic credit role as it does today, albeit possibly operating with greater efficiency and effectiveness. That is, the SBA would attempt to make a large number of loans to a wide range of small businesses. This is intended to diversify the credit risk taken on by the SBA and to maximize the number of loans going to relatively smaller businesses, whose need for government assistance is presumed to be greater. In pursuit of this objective, the SBA has decreased the average loan size in the 7(a) program from $241,000 in 2000 to $167,000 in 2004, according to the OMB. At the same time, the number of businesses receiving loans increased from 43,748 to 81,133. Others feel that this approach leads the SBA to lend most of its funds to firms that do not really need the assistance. At the extreme, some analysts believe that SBA lending is no longer necessary. In her April 6, 2006 testimony before the Senate Committee on Homeland Security and Government Affairs, Veronique de Rugy of the American Enterprise Institute questioned the need for the SBA s credit function. She argued that the perceived need for SBA loan guarantees is based on a flawed notion that a market failure prevents small businesses from obtaining adequate credit in the free market. In fact, de Rugy contended, the private market efficiently provides needed capital to small businesses. She cites a 2002 Federal Reserve Board report, 17

18 which notes a correlation between demand for financing and the pattern of debt growth among small businesses between 1997 and This indicates that supply of financing in the private market is meeting the demand from small businesses. For reasons such as advances in information technology, including credit scoring, private capital has become very accessible to small businesses. If, as de Rugy stated, a market failure does not exist, the SBA s loan guarantee programs would be considered wasteful and potentially harmful to small business competition. Furthermore, de Rugy said that, even assuming the presence of a market failure, SBA loan programs do not produce significant benefits for small businesses. SBA lending represents only 1% of total small business loans. Therefore, the 99% of small businesses forced to obtain financing in the private market are placed at an unfair disadvantage. At best, in de Rugy s estimation, SBA loan programs are an unnecessary burden on the taxpayer. At worst, they are detrimental to a large portion of small businesses in this country. Some analysts support a position between the status quo and abolition of the SBA s lending activities. They accept that most small businesses are now able to obtain funds on commercially reasonable terms, without SBA assistance. However, they believe that there are two important exceptions which represent a market failure that is unlikely to vanish on its own. First, they believe that minorities still face non-economic barriers to obtaining loans on fair terms. Second, they believe that credit should be easier for high impact entrepreneurs to obtain. These are companies, such as Google, which provide positive externalities to society that are not captured as profits by the company itself. For example, the societal gain from more efficient internet access is held to be much greater than the profits accruing to Google. A lender that focuses only on the finances of a potential new Google might not be willing to accept a risk/reward trade-off that would in fact benefit the nation. Focusing lending on minorities and high impact entrepreneurs is discouraged by the political and bureaucratic pressures on the SBA. First, concentrating lending on these categories increases risk by decreasing diversification, raising the likelihood of more volatile results. Second, the average level of risk will be higher in general for these borrowers, leading either to substantially higher interest rates or larger credit losses, neither of which are politically popular. The politician s ideal would be for the SBA to lend to a very large number of businesses while costing the taxpayer very little. This pushes the SBA towards lending to those who do not really need the help, since they have low financial risks and therefore could borrow commercially. In practice, the SBA is likely to continue in its present role, but with an emphasis on superior operational performance. There is little political momentum to abolish SBA s lending or to sharply focus it. 18