Declining loans? Whose de-fault is it?
The default rate on SBA-backed loans has quadrupled since 2004, which may help explain why banks are making fewer of those loans.
Amid all the concerns about the decline in SBA lending is one relatively simple explanation that gets little attention: skyrocketing default rates.
The default rate on SBA-backed loans given to franchisees has more than quadrupled since 2004, according to information prepared by the Coleman Report, a newsletter out of California that tracks the SBA lending market. In 2004, the default rate for franchisees was 3.1 percent. By 2008 it was 13.4 percent.
Meanwhile, 2 percent of franchisees receiving SBA loans failed and liquidated last year, an increase of two-thirds over the year before and more than six times the rate of failures as in 2004.
Both figures reflect an overall increase in loan defaults in the SBA program, in which businesses had an 11.9-percent default rate last year, up from 2.4 percent in 2004.
The higher default rates may help explain a 57-percent decrease in SBA-backed loans in the last three quarters of 2008 and a general decline over the past couple of years. That decrease has generated deep concern among lenders and small business advocates as well as government officials who view small business creation as a key to any economic improvement.
In February, Congress passed an economic stimulus package with provisions designed to increase SBA lending. The stimulus package reduced fees and increased the government guarantee on 7(a) loans to 90 percent, and it enables the agency to lend to dealers who sell loans on the secondary market - which many believe would stimulate lending.
The higher default rates on SBA loans in recent years are a likely symptom of the decline in the nation's economy. But many of the defaults predate the serious economic downturn. That suggests the numbers may reflect one of the causes of the recession: banks' loosening lending standards in a period of historically low interest rates.
Darrell Johnson, CEO of the franchise information firm FRANdata, said that while the number of loans in default is near 12 percent, the dollar amount defaulted is much lower, less than 5 percent. In other words, the loans more likely to go into default were for lower dollar amounts.
Companies with higher default rates among their franchisees typically require smaller loan amounts. The 10 companies listed on the Coleman Report with the worst default rates - ranging from 55 percent to 86 percent - had an average SBA loan amount of $173,060. By contrast, the companies with the 10 best default rates - or the 10 companies with the most loans and no defaults - had an average loan of $742,594.
Lenders commonly performed less due diligence on smaller loans, because the amount of paperwork required for an SBA loan is the same whether it's $50,000 or $500,000. So banks didn't take as deep a look at borrowers of loans for less than $150,000 - the peak amount in the agency's now-defunct "low documentation" program that required less paperwork. "The smaller size loans were getting less bank scrutiny, that's the issue," Johnson said. "With less bank scrutiny, they were defaulting at a higher rate."
"In a rising economy, it's still problematic," he added, "but it is accentuated because of the down economy, when defaults would be up, anyway."
Johnson attributed much of the reduction in SBA lending to a reduction in bankers making smaller loans because of the default rate and the departure of some large lenders that had specialized in low documentation loans. Indeed, the most significant reports of lending problems have come from franchises that have a lower initial investment cost.
Johnson doesn't think the lending environment will change anytime soon. Lenders are making fewer, more conservative loans and given the cost are likely to focus on bigger amounts. Banks "are being overly conservative now," he said. "And that over-conservatism is being applied to a greater extent to smaller loans."
That franchisees had a 1.5-percent higher default rate isn't entirely a surprise - Johnson himself authored a report more than a year ago with a similar finding. He believes it's rooted in the fact that many franchises require smaller loans and are therefore more likely to default.
And Bob Coleman, publisher of the Coleman Report, stressed that not too much should be read into the difference. He said that the majority of franchise loans are in the 7(a) program, which has a higher default rate than the 504 program, which is tied to property. The default rates include numbers for both programs.
Fixing the problem?
The higher rate of defaults has not gotten past the SBA, which in attempting to solve the problem announced in early February that lenders should restrict the value of "goodwill" in a loan to 50 percent of the total amount and no more than $250,000.
The SBA's decision led to an outcry among brokers and lenders who said the restriction would bring loans for business acquisitions to a virtual standstill. "Moving goodwill to 250 does not help us in any way, shape or form," said Steve Mariani, founder of North Carolina-based Diamond Financial. "All the people on employment lines who would like to get a loan to buy a franchise or a business, you're stopping them from getting that business. It's just been an absolute mess the last couple of weeks."
That outcry did cause the SBA to back off a little by the end of the month. The agency said any loans exceeding the goodwill cap could be submitted to its central processing office for the next six months. That didn't pacify critics of the plan, who say that at the very least sending the applications to central processing would delay loans and generate more paperwork. And a definitive goodwill cap is still possible.
Goodwill is the value tied to a business above its physical assets, or the premium associated with buying an established business, rather than starting one from scratch. Many established businesses on the market have some sort of goodwill value attached to them, especially service-oriented companies that have less equipment and buildings.
Franchises likewise have a certain amount of goodwill value, such as the brand name and the territory rights, said Steve Mize, managing partner at Gulf Coast Financial Valuations, a business valuation firm.
The SBA contends they're also the riskiest. In a memo to SBA employees in February, Grady Hedgespeth, director of the agency's office of financial assistance, said that many lenders don't finance goodwill on conventional loans, and that neither should an SBA backed loan.
Mize disagreed, and he noted that the number of service-oriented businesses with higher amounts of goodwill value is increasing. "The less risky deals are the deals with simple business models and higher amounts of goodwill and good customer diversification and good management," he said. "The riskiest are high capital businesses with higher capital expenditure requirements and high working capital requirements."
Mize said that 76 percent of the loans made for business acquisitions last year would not qualify under the new cap. It's uncertain how many SBA loans are for business acquisitions, but Mize said those sales nevertheless represent an important piece of any economic improvement.
Sales at businesses tend to stagnate in the years when the owner is closer to retirement, he said. If the business can be sold, then it would bring in a young, energetic owner who could bring in new ideas and generate sales and employment. Restricting goodwill would keep those owners from selling. "By limiting financing on goodwill, they're limiting the value on the most valuable assets that the business can own," Mize said.