One of my favorite quotes comes from Spanish philosopher George Santayana who said: "Those who cannot remember the past are condemned to repeat it." Believe it or not, we can draw a connection between this 110-year-old quotation and small business lending today.
The U.S. Small Business Administration is allowing history to repeat itself, as it tacitly enables small business lenders to offer government guaranteed 7(a) loans in ever-larger amounts with yet smaller collateral contributions from borrowers. Somewhere Alan Greenspan is muttering "irrational exuberance."
The 7(a) loan program is the darling of small business lending as it offers the best deal for banks which participate in the program. During good times, small business lenders often gorge themselves on 7(a) loans - so much so that the program gets maxed out. And then the banking community cries wolf to Congress. This has happened many times during the program's history, and we are on the verge of seeing it again in 2015. Some estimates show that the program could hit the $18.75 billion cap imposed by Congress before Sept. 30, the end of the fiscal year.
Times are good, so why is this a bad thing? Well, as always, the devil is in the details.
Earlier this month, small business finance authority, Bob Coleman wrote about the excesses that lie in one dark corner of small business lending: 100% financing by some SBA 7(a) lenders.
I often wonder how some lenders get away with this. U.S. taxpayers are unwisely put at risk with such reckless commercial lending - the equivalent of handing a 16-year-old your keys and a six-pack.
Now I have certainly heard the justifications over the years about giving these loans only to doctors, veterinarians and dentists (the kind of borrowers every bank covets) on the ill-advised premise that these folks are always the lowest credit risks. Sadly, that myth needs challenging
You don't have to be a banking-school trained lender to understand the common sense rule of "having skin in the game." Get a real equity contribution from a small businessperson on their loan, and you can sleep better at night knowing your default risk has been mitigated some. Give them a pass because they spent more time in some ivory tower than you did, and don't be surprised if they walk away from your loan when the going gets tough.
We've seen this movie before, and it doesn't end well. Teenagers should never run into the cemetery at night while being chased by a serial killer. Should the agency dig into this a little deeper, they'd note that same proverbial cemetery is littered with the dead carcasses of former 7(a) lenders who once marketed 100% financing with abandon. My hunch is that many of their liquidations originated from these very same adolescent lenders.
With all-time high secondary market premiums on SBA 7(a) loans and some lenders providing 100% financing, it is no wonder the 7(a) program is about to run out of money and require additional allocations from Congress. Loans from the 7(a) program certainly have their place -- for business acquisitions, partner buyouts, working capital loans, and so forth -- just not for fixed assets like commercial property and heavy equipment.
As rates move up (and they have nowhere else to go but up from here), 7(a) prepays will accelerate as borrowers refinance-out of 7(a) loans and fewer and fewer small business borrowers will be duped into floating rate loans on real estate as the media screams about rising rates. Floating rate 7(a) loans on commercial real estate are the way bankers maximum their secondary market premiums, assuming they can sell these inferior terms to unsophisticated small business owners.
The 7(a) premium bubble burst is coming, and then there will be a regression to the mean of historic premiums, as there always is. We're all for the secondary market providing added liquidity, but it needs to be sensible and based on tried-and-true lending standards, among other things. The current secondary market for SBA 7(a) loans feels euphoric and outlandish. It too will end.
Meanwhile, the SBA's 504 program, which almost always offers a better deal on commercial real estate and equipment, has lending authority to spare. Congress continues to debate whether or not to re-enact a refinancing provision which could be a savior for many small businesses as they hurl toward the so-called Wall of Maturities. SBA 504 volume is down as bankers would rather hustle their prospects into 7(a) loans to take advantage of significant premiums from a percolating secondary market.
Fixed assets should be financed by fixed interest rates. That's Business 101. Of course, so does having a little skin in the game when you borrow money. Maybe wiser heads will soon prevail around this whole matter. These programs are too important for America's entrepreneurs to screw them up for near-term greed. It's time for some in the industry to grow up, become more responsible and not repeat the mistakes which plagued us in the past.
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