Key guarantee terms: Small Business Administration (SBA) 7(a) program

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Jeffery Lyons
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1 OVERVIEW OF LOAN GUARANTEE PROGRAMS A wholesaling approach to expanding private sector capital availability. Guarantees cover potential losses to encourage private lenders to make riskier loans. Guarantee programs have the potential to expand capital availability at less cost and more efficiently than through direct lending programs. Key guarantee terms: Type of loss covered: principal, interest, collection costs Level or percentage of loss guaranteed Order of loss payment: first loss, second loss, or pro rata Maximum guarantee amount Time period (term) of guarantee Timing of loss payment (direct pay versus post-collection) Three primary program types: Small Business Administration (SBA) 7(a) program State government loan guarantee programs for general small business credit, export financing and other purposes, e.g., MassDevelopment has 3 programs: an export working capital guarantee, a mortgage insurance program for manufacturers, and a guarantee program for specialize high tech facilities. Capital Access Program (CAP) is the most common state guarantee program, which uses a portfolio-based guarantee rather than individual loan guarantees.

Key guarantee terms: Type of loss covered: principal, interest, collection costs Level or percentage of loss guaranteed Order of loss payment: first loss, second loss, or pro rata Maximum guarantee

2 Guarantee Advantages Operates on an efficient wholesale basis using existing banks and finance companies to deliver loans to firms Promotes relationship-building between businesses and banks; can lead banks to change their risk perceptions and longer term lending practices Requires less capital to generate a given level of lending; only need to fund expected losses or reserves not full loan amount Disadvantages More complex to implement since they involve financial and legal arrangements between three parties Depend on lender acceptance and buy-in to work Guarantor needs financial capacity to honor guarantees Create an incentive for firms to use more debt

lending; only need to fund expected losses or reserves not full loan amount Disadvantages More complex to implement since they involve financial and legal

3 SBA 7(a) Program By far the largest loan guarantee and small business finance program. Over $ 9 billion in guarantees issued in FY2001. Guarantees up to $2,000,000 on private bank or finance company loans for working capital and/or fixed assets. Guarantees are for up to 85% on loans < $150,000 and 75% for loans > $150,000. Interest rate capped at prime % to prime %. depending on their size and maturity. Loan terms up to 10 years on working capital and 25 years on fixed assets are allowed. In FY1995, $23.5 billion 7(a) portfolio represented 6.7% of outstanding commercial & industrial loans by commercial and savings banks. Share declined since 1995 but it is probably still significant. The (7a) program allows lenders to provide longer terms loans, lower equity requirements, and serve more start-up, women and minority-owned. Based on 1996 GAO study: Average 7(a) loan term was 13 years vs. 3.3 years for nonguaranteed loans, reflects fact that 51.5% of non-guaranteed loans were lines of credit vs. 2.1% for 7(a) loans. 22.1% of 7(a) borrowers were start-ups versus 0.4% for non-guaranteed loans. 7(a) borrowers are also more likely to be minorities (13.5%) than firms receiving non-guaranteed loans (8.2%). These findings are consistent with results in Haynes study of the SBA 7(a) program, and lender survey data.

Interest rate capped at prime + 2.25% to prime + 4.75%. depending on their size and maturity. Loan terms up to 10 years on working capital and 25 years on fixed assets are allowed. In FY1995, $23.

4 SBA 7(a) Program continued Two important innovations over past 20 years: Preferred lender program where all guarantee decisions are delegated to private lender. LowDoc program uses streamlined process for loans under $100,000 and has lead to smaller average loan sizes. Findings from studies of 7(a) program: Haynes study: strong evidence that SBA guarantees expand credit for higher risk borrowers but less evidence that they overcome restricted lending in concentrated markets. Price Waterhouse 1992 evaluation found higher survival rates, faster revenue growth and much higher job growth for 7(a) borrowers versus comparable firms without guarantees GAO lender survey found that 82% of lenders would not have made their loans or made them on far more stringent terms with the guarantee Study by Hunter found that the guarantees levels affect lenders care overseeing loans and default rates. Using a SBA guarantee to refinance loans increased default probability by 12%. Implications for practitioners: 7(a) program expands credit availability on better terms Work to maximize use of 7(a) program by local lenders Apply lessons of 7(a) program to other guarantee programs o Avoid guaranteeing refinanced debt, o Create incentives for strong lender care, o Tailor guarantee levels and fees to borrower risk level

Findings from studies of 7(a) program: Haynes study: strong evidence that SBA guarantees expand credit for higher risk borrowers but less evidence that they overcome restricted lending in

5 State Guarantee Programs Limited information exists on the extent and use of these programs Some states target guarantees to serve businesses or financing needs that are not well served by the 7(a) program o Agricultural enterprises o Export finance o Small loan Duplication of 7(a) programs seems fairly common States would be better served expanding use of the 7(a) program rather than substituting state guarantees for federal ones

Agricultural enterprises o Export finance o Small loan Duplication of 7(a) programs seems fairly common

6 C apital Access Program Portfolio-based guarantee. Borrower pays fee, 3 to 7% of principal, that state/local government CAP program matches. Fee and match are deposited into a dedicated loan loss reserve at the participating bank. This reserve covers losses on CAP loans made by the member bank, with no additional recourse. 20 states had CAP programs in 1999 with 315 participating banks and $1.2 billion in loans. Thee states (CA, MI, MA) accounted for 68% of CAP loans Some states target CAP loans to distressed areas or minority- +/or women-owned firms by increasing the state match amount: One quarter of CAP loans in IL and WI are to minorityowned firms Close to 30% of CAP loans in CA and OR are in low and moderate-income census tracts. Two cities, New York and Akron, have CAP programs CAP loans seem to serve firms that would not otherwise receive loans: higher loss rates (3.9% cumulative), modest loan size (59,000) and higher % of start-ups (18% in MA, 15% in IL) Best Practices for CAP program include: Active marketing and enrollment of banks Significant funding of reserves with capacity to expand them over time Use broad criteria for eligible loans with incentives to target lending to specific groups or areas

20 states had CAP programs in 1999 with 315 participating banks and $1.2 billion in loans.

7 GUARANTEE PROGRAM LEVERS AND POLICIES Targeting Policy: compliment role of 7(a) program, but still broader enough to secure lender interest and participation; Financial product and policies differ for those of RLFs: Type of the guarantee provided Percentage of the project and loan guaranteed Term of the guarantees Guarantee fee or return Create incentives for active lender underwriting and oversight: Set maximum guarantee coverage (80% or less) Reduce guarantee as conditions reduce loan risk Security for guarantee: Cash reserve or general obligation Underwriting criteria: Need to reflect targeting and financing policies. Underwriting, monitoring, and collection process: Role of guarantor versus lender in underwriting and approving guarantees, overseeing loans, and addressing loan defaults. Maximize lender role and minimize duplication of effort between lender and guarantor: Standardize guarantees levels Delegate guarantee commitment to lenders Rely on lender s analysis and documentation Reliance on lender will reflect extent of lender risk exposure and incentives.

oversight: Set maximum guarantee coverage (80% or less) Reduce guarantee as conditions reduce loan risk Security for guarantee: Cash reserve or general obligation Underwriting criteria: Need to

8 GUARANTEE PROGRAM CHALLENGES Building lender participation in the guarantee program to ensure its availability and to gain sufficient scale for impact and reduced losses. Establishing credibility for the guarantee quality so that private lenders will trust it. Ensuring sufficient reserves or funding to have a credible guarantee. Creating an efficient approval process so that the program is not too cumbersome and slow for lenders and borrowers. Introducing a 3 rd party guarantor adds an additional layer of review and added complexity for the transaction. Minimizing adverse selection problems that can generate high losses. Achieving a level of guarantee needed to leverage private lending while still having enough lender exposure to ensure the lender closely evaluates and monitors the loan.

Creating an efficient approval process so that the program is not too cumbersome and slow for lenders and borrowers.

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