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U.S. Small-Business Aid May Create $300 Billion of `Junk' Loans

By Laura Keeley and David Henry
July 26, 2010

President Barack Obama is on the verge of creating as much as $300 billion in credit for small businesses as bankers raise doubt about whether there’s demand for new loans and how much will be repaid.

The U.S. Senate may vote this week on a bill to funnel $30 billion of capital to community banks, whose business customers typically are small firms. Banks could leverage the sum to make $300 billion in loans that create jobs, according to a Senate summary. That could more than double the commercial and industrial loans at eligible banks as of the first quarter, according to data compiled by KBW Inc.

Bankers say the problem isn’t scarce credit, it’s lack of demand from creditworthy firms in a weak economy. The result may be more loans given to distressed firms and higher losses. While bank regulators don’t compile default rates, the biggest lenders have charge-offs of 4 percent to 14 percent tied to small businesses. Eliot Stark, managing director at Capital Insight Partners Inc., said their credit record resembles “junk.”

“The highest demand for loans is from the companies least qualified, the companies that have really struggled because of the economic downturn,” said Stark, a former Comerica Inc. executive whose Chicago-based investment bank helps community lenders raise capital. The way lawmakers see it, “everyone’s a good borrower, and that’s just not the case.”

Vote Pending

Obama’s program passed the House last month and is awaiting Senate approval after disputes over the cost, tax breaks added to the bill and concern that it’s another bank bailout like the Troubled Asset Relief Program. Terms call for banks with assets of less than $10 billion to receive U.S. Treasury Department investments in preferred stock or other instruments to promote small-business loans, according to Senate documents.

“If we can help the big banks, then we should certainly be able to help small-business lending,” Obama said June 30. He’s been pushing to increase credit for entrepreneurs since October and summoned leaders of the biggest banks to the White House in December. The Small Business Administration estimates the nation’s 30 million small firms defined as those with fewer than 500 employees create 64 percent of new jobs.

The Independent Community Bankers of America is “wildly supportive” of the bill, said chief economist Paul Merski, whose Washington-based lobby represents almost 5,000 lenders. The American Bankers Association favors passage and the National Federation of Independent Business, which lobbies for small companies, says it supports financing for “creditworthy” firms that have trouble getting loans.

Cost Estimate

Taxpayers could break even if the program is properly structured so that interest and fees cover losses, Stark said. Banks will be charged an initial interest rate of 5 percent, declining to 1 percent if they increase small-business loans or rising as high as 7 percent if the loans stay the same or decrease, according to Richard Carbo, spokesman for the Senate Small Business and Entrepreneurship committee.

The program will earn $1.1 billion over 10 years, and “this is nothing like TARP,” Carbo said. With no cost to taxpayers, “this is one of the most efficient bang-for-your buck initiatives you can put forward,” Gene Sperling, counselor to the Treasury secretary, said in an interview.

Bank loans to small firms fell 5.6 percent to $670 billion as of March from $710 billion in June 2008, according to the Federal Reserve. First-quarter commercial and industrial loans for commercial banks with $10 billion or less in assets -- the threshold for the U.S. program -- totaled about $240 billion, according to analyst Melissa Roberts at KBW in New York.

Default Rates

Bank of America Corp., the biggest U.S. lender, is trying to “make every good loan we can,” said David Darnell, president of global commercial banking, in a June 3 statement. “Our clients are telling us that until they see sales pick up, they are reluctant to hire and invest.”

Wells Fargo & Co., which says it’s the biggest small- business lender, is “sitting here with tons of liquidity and we’re marching double time in search of more loans,” Chief Executive Officer John Stumpf said in an interview. “In most cases when I hear stories about small businesses not getting loans, it’s the case that more credit will not help them. They need more equity, they need more profitability.”

Nationwide default rates for small businesses aren’t known, say U.S. officials, with spokesmen for the Fed, Treasury and the Federal Deposit Insurance Corp. saying their agencies don’t compile a figure. Among the group of banks surveyed by KBW’s Roberts, 2.81 percent of loans were non-current or charged off as of the first quarter.


Other gauges show higher defaults, with the SBA reporting a 6.8 percent rate this year on its main “7(a)” loan program through May, higher than junk bonds. Defaults on U.S. corporate speculative-grade debt since 1981 averaged 4.5 percent, according to Standard & Poor’s.

JPMorgan Chase & Co., ranked second by assets, reported small-business charge-offs fell to 4.04 percent in the second quarter from 4.70 percent a year earlier. Charge-offs for all commercial loans at the New York-based bank were 0.74 percent.

Bank of America wrote off 14 percent of small-business loans in 2010’s first half, more than 10 times the rate for other commercial loans. Spokesman Jefferson George declined to comment on the default rate. Citigroup Inc.’s Robert Julavits said the New York bank doesn’t disclose its defaults.

More than 240 banks have failed since the start of 2009 as consumers and businesses fell behind on loans. Most of the failures were community lenders.

Small-business loans show higher credit losses than larger companies in “good or bad” times, said American Express Co. CEO Kenneth I. Chenault in a June 2 teleconference. Spokesman Tom Sclafani said AmEx, which offers a line of credit cards to small firms, doesn’t release default data.

Borrowers Balk

The biggest card firm dedicated to small business was Advanta Corp., based in Spring House, Pennsylvania. Advanta cut off its approximately 1 million accounts last year after defaults soared to 20 percent. They eventually topped 50 percent as small firms were “devastated” by the recession, according to Advanta, which went bankrupt in November.

Small borrowers are higher risks because their size leaves less room for error, bankers say. Half fail within their first five years, according to the SBA, and the recession eroded the value of hard assets such as property and equipment to pledge as collateral, said Alfred Osborne, senior associate dean of the UCLA Anderson School of Management in Los Angeles.

“We can create lots of jobs making bad loans,” NFIB chief economist William Dunkelberg said. “We did that during the housing bubble.”

To contact the reporters on this story: Laura Keeley in New York at lkeeley@bloomberg.net; David Henry in New York at dhenry19@bloomberg.net

Source:  http://www.bloomberg.com/news/2010-07-26/small-business-program-from-obama-may-create-300-billion-of-junk-loans.html



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