Axe the SBA

The Small Business Administration is of little value. It gives loans to noncreditworthy businesses, shifting funds away from larger enterprises deserving of credit. Pro or con?

Pro: Gratuitous Crutch

Congress created the Small Business Administration in 1953 to fix an ostensible problem: Lenders passed over large numbers of small businesses that, if given access to a loan, would generate untapped economic growth. In fiscal year 2008, the SBA will guarantee $28 billion in loans, mainly through its flagship 7(a) loan program. Plenty of evidence indicates, however, that the time has come for Congress to abolish the SBA loan programs. Here are just three reasons.

First, academic literature shows that private capital markets already efficiently allocate loans to small businesses. Banks give credit at the right price to companies that deserve it at that price, including small businesses.

Empirical studies prove that point, too. In 2002, the Federal Reserve Board reported that the demand for small-business financing closely tracked the pattern of debt growth from 1997 to 2002, suggesting a correlation between the demand and supply of financing. Although conditions deteriorated substantially in 2001 and the beginning of 2002, small businesses didn’t find financing conditions onerous and weren’t suddenly having more difficulty obtaining credit during that period.

Second, shutting down the SBA would hardly stop small businesses from getting loans. Only 1% of small businesses receiving loans (long- or short-term) in a given year receive them from the SBA. And while 29% of 7(a) loans go to minority business owners, SBA distributes loans to roughly only 3% of all minority-owned firms. The same trend is true for women-owned firms. In other words, the SBA is largely irrelevant in the capital market. Even the National Federation of Independent Business, the chief small-business lobbying group, agrees. “Our members tend not to rely on SBA loan programs,” Says Andrew Langer, the NFIB’S manager of regulatory policy.

Finally, even though SBA loans tend to flow to riskier borrowers—as its mission intended—it’s unlikely that these businesses promote economic growth. SBA loans go to businesses that conventional providers of financing have rejected. This means these loans go to the enterprises least likely to create stable employment, improve technology, or enhance national productivity. Default rates on SBA loans are roughly 17% as opposed to 1.5% for FDIC-insured bank loans and 4.3% for credit card loans.

It is time to abolish the SBA loan programs.

Con: A Crucial Helping Hand

Abolishing the SBA would not only hurt small business by shutting down key programming that aids in business development and growth, but would also ultimately strike at the foundation of our nation’s economy. Programs offered by the SBA have a proven track record of effectively aiding very small businesses and our nation’s self-employed. Owners of small businesses continue to face considerable challenges in starting and enhancing their enterprises.

One key obstacle is their ability to attain funding. According to a recent online survey by the National Association for the Self-Employed (NASE), nearly 60% of self-employed individuals say they have been forced to rely on personal finances as their primary source of funding when starting their business. That habit continues after the business is established, with 36% continuing to use personal savings as an ongoing means of finance. Big business, on the other hand, is rife with players who could afford to invest their private stashes—but rarely do. Why must the entrepreneur bear the heavier burden?

Historically, traditional lending sources such as banks and other financial institutions have not met the funding needs of micro-business owners. The self-employed and micro-business communities generally need small infusions of capital over their lifetimes. The small scale of the loans needed by micro-businesses as well as lending institutions’ perceptions that startups and small enterprises are risky investments have led to a lack of capital resources.

SBA loans such as those available from the Micro-Loan Program fill this funding gap. Access to SBA Micro-Loans is an important avenue to help businesses grow and boost the local economies.

In addition to financing, SBA offers training programs such as those provided by Small Business Development Centers, which give essential, one-on-one assistance to current and prospective entrepreneurs. The centers support entrepreneurs throughout every stage of their business’s creation and growth. And the SBA Office of Advocacy has long served as a strong voice within government to ensure that small business gets a fair shake in the regulatory process.

Opinions and conclusions expressed in the BusinessWeek Debate Room do not necessarily reflect the views of BusinessWeek, BusinessWeek.com, or The McGraw-Hill Companies.

Reader Comments

John

One alternative is to allow nonprofit organizations to administer and manage a guarantee program similar to student lending programs. A nongovernmental entity could probably manage the program better and decrease the default rate.

Terrie

If the SBA has outlived its usefulness, perhaps there's a different model that would provide the advocacy that at-risk small businesses need but in a way that is more subject to the forces of the free market. Maybe a pool or fund created and administered on a smaller scale, perhaps at the state rather than federal level.

Scott

As an SBA lender for 26 years, I know de Rugy's numbers are way off. The SBA provides more than 20% of available long-term financing for small businesses, is the only reasonable source for new businesses, and has a default rate of less than 6% with loan losses of less than 2% (my bank's results are less than half these numbers). It remains one of the few government programs that generates more tax revenues than it costs.

Kelly

Scott needs to cite his sources if he wants to attack the numbers used by de Rugy, who has been well-published in peer-reviewed literature on this subject, using those figures.

Veronique de Rugy

Scott,
You mention that SBA provides 20% of long-term financing for small businesses. Small business long-term financing is a government-created product. Small businesses have small needs and are known to survive on average less than five years, which explains the low supply (and demand) for long-term financing. It doesn't seem like a major accomplishment for the government to create an artificial market and then capture 20% of it (and by the way, the actual number is 40%).

Also, the default rates I use in my piece were given to Senator Coburn by the SBA itself after a hearing in April, 2006. These numbers are part of the public record, and you can check them out. See Testimony before the Committee on Homeland Security and Governmental Affairs on the "Effectiveness of the Small Business Administration," April, 6 2006.

However, I am not surprised that, as an SBA lender, you would be so protective of the program. During that same hearing, it was made public that SBA lenders are the true beneficiaries of SBA loan programs. In the transcript of the hearing, you will find an acknowledgment by the chairman of the National Association of Government Guaranteed Lenders (NAGGL) that "return on assets of SBA loans can easily exceed 5%, and return on equity can exceed 70%." A 70% return on investment is remarkably high. Returns on investment for the two biggest banks in America--Citigroup and Bank of America--are roughly 18% and 16% respectively. Even the credit-card company American Express, which enjoys a higher return because it requires fewer assets than commercial banks to conduct its business, doesn't show such incredible returns. In January, 2007, its return on investment was 34.2%.

For details on how SBA lenders benefit the most from the SBA programs, look out for my upcoming paper, "Banking on the SBA," on Mercatus's Web site.

Scott

Kelly/de Rugy, I have no idea what the source of Senator Coburn's numbers are. My sources, however, are the SBA portfolio monitoring system (as of 3/31/2007), which was created at the insistence of Congress, and the SBA default and charge-off data secured under the Freedom of Information Act for loans funded from 10/1/2000 to 9/30/2006. The first source indicated "problem loans" (5.4%) vs. defaulted loans and a repurchase rate--which always is less than charge-offs--of 1.8%. The second source had defaults at 6.8% and charge-offs at 1%. As far as creating "stable employment" is concerned, more than 25% of SBA loans are to new businesses, thereby creating new jobs. Even if Dr. de Rugy's 17% was correct, that would mean 83% of these loans created new employment.

The source regarding SBA loans generating more tax revenues than it cost is an independent audit performed by Price Waterhouse when the agency was first attacked in the late 1970s.

The demand for long-term financing is controlled by banks, not borrowers, as Dr. de Rugy should know. Lenders do not want to lend long term because of the uncertainty of the future. Small businesses, especially new businesses, need longer terming to reduce cash-flow requirements. The SBA guaranty provides the vehicle for banks to make these longer-termed loans. I appreciate that Dr. de Rugy acknowledges 40% of these products are delivered by the SBA.

While it is true an SBA lender who sells his loans can reap a significant return, less than half the SBA loans funded are ever sold. Community banks, like mine, do not sell their loans and actually make a lower return on them than on our conventional loans after the 0.41% paid to the SBA is deducted. We chose to make loans, which normally would be declined, because the SBA mitigates most of our risk. Our return comes from a long-term relationship when these less-creditworthy borrowers "graduate."

Veronique de Rugy

Scott argues that defaults are only 6.8%. However, we know that this number is meaningless, because it doesn't reflect the average default rate of all loans, only the percentage of loans defaulting in the last year. When loans are separated by cohort group, 16% to 18% of SBA borrowers default (SBA data).

In recent years, many academics have done the math and confirmed SBA data. See for instance, Glennon, Dennis and Peter Nigro's "Measuring the Default Risk of Small Business Loans: A Survival Analysis Approach" (Journal of Money, Credit, and Banking 37(5): 923-947 published in 2005). They measure the default rate by looking at a sample of seven-year maturity SBA 7(a) loans disbursed from 1983 to 1998. Approximately two-thirds of the loans in their sample went to existing firms and one-third to startups, with a vast majority going to firms with 25 or fewer employees. They find that default rates are generally around 15%. This number is higher than the GAO's 2003 ("Opportunities for Oversight and Improper Use of Federal Dollars," GAO-03-1006, p. 102) estimate that the default rate on 7(a) preferred lender loans had averaged about 14% in recent years.

Second, Scott's assumption that any dollar of government spending is good and creates new jobs is naïve. He says that even if loans defaulted at 17%, that would mean 83% of new loans would be for more jobs. If that's the case, why don't we get private banks out of the lending market entirely and turn it all over to the government if they're so good at producing wealth? The simple answer is that whenever the government gets involved in the credit market, bad firms crowd out good firms--actually making everyone worse off.

Also, the implicit assumption that bringing a small business to life that would not have existed without the SBA is worth the cost is naïve and unfounded. For one thing, Scott needs to demonstrate that claim. We know that SBA is not willing to answer that question since it doesn't measure the performance of its loans. What we know, though, is that we can read about every local SBA office and what SBA calls its "success stories." There is no doubt that some of these stories are good examples of entrepreneurship. Most, however, are about businesses basically managing to stay afloat rather than maturing into fast-growing enterprises and creating jobs. Also, these are nothing more than anecdotes, which is hardly a basis for sound cost-benefit analysis or for statements about the effectiveness of job creation via the SBA loan programs.

Finally, isn't the data showing that the SBA doesn't guarantee more than 1% of all small-business loans in a given year sufficient evidence that its program is irrelevant and that small businesses have good access to the capital market?

Scott

De Rugy continues to demonstrate she has no concept of the real world. To state "bad firms crowd out good firms" in today's very competitive economy is absurd. As is the 14% to 17% default rate.

She obviously has never worked in lending. First, SBA loans are one of many products lenders use to service the full spectrum of borrowers. Second, if she knew the industry, she would know a much greater percentage of loans are problem loans than ever go into default. With a 17% default rate, SBA lenders would have 25% to 35% of their portfolio in problem loans. Every problem loan creates many times more work to service than it did to originate. While there are always poor performers, I and lenders like me would have been fired years ago if our defaults approached 10%, let alone 17%, especially since 25% to 50% of SBA loans are not guaranteed and therefore the responsibility of the lenders, not the government. The 70% return de Rugy mentions would be impossible to attain with such a portfolio. All that said, the most important number is loan losses--1.8% during the past 12 months. That's nearly double what most banks would consider acceptable, but excellent for higher risk loans and a number that would be much higher if the default rate was 17%.

De Rugy continues to focus on 1% of total loans instead of 40% of long-term loans and the only reasonably priced source of capital for new businesses. I wonder if she has her iPhone yet. I only mention it since its creator, Apple Computer, along with Federal Express and Winnebago, all benefited from SBA loans a long time ago. Of course they represent less than 0.001 % of all SBA loans and the program is so "irrelevant," we should abolish it. Right?!

Michelle

Interesting comments. It is certainly easy to find and to quote facts and figures to support almost any side one wishes to take on a given subject. It is quite another to actually be involved in a process. The opinion of someone working from the ivory tower position of de Rugy is much less credible to me than that of someone who actually has worked in, or is still working in, a field of debate, such as Scott. It is interesting to me that a "learned" person would choose the side of big business, which is so heavily subsidized. The amount allotted to the SBA is a drop in the bucket compared with all of the pork spread about to multimillion-dollar--rather, multibillion-dollar--businesses that hardly need this money, except to keep their executives and shareholders happy. In any government agency, there will always be a measure of corruption, waste, and misuse; it is the nature of the beast. However, I for one will continue to root for the little guy as long as there are any government subsidies of businesses. No need to rush out to make a three- to four-paragraph response to my comments. I'm sure anyone can come up with his or her own version to refute my position, and I am far too busy to pick apart a rebuttal.

Veronique de Rugy

First, I am glad to see Scott is now using my 40% number instead of his original 20%. I am taking that to mean he agrees my data might not be as bad as he thought it was. Second, this 40% still means that the private sector is serving a large majority (60%) of small businesses asking for a long-term loan. Third, the number of firms asking for such long-term loans is minuscule. Quoting data from Dunn and Bradstreet, the Chairman of NAGGL--NAGGL lenders issue roughly 80% of all 7(a) loans--explained that 80% of small businesses have revenues of $100,000 or less. He continues by explaining that these companies have very small needs and are not in the market for long-term loans. Finally, I am still waiting for Scott to show me how the SBA can claim to be relevant in a market that serves 99% of small businesses getting a small business loans (short and long term) in a given year.

I might not have worked in a bank, but I know why SBA lenders do not get fired for lending money to borrowers who have a high probability of defaulting. It's because taxpayers are the ones paying the cost--not the bank. If the borrower defaults, the SBA reimburses the lender up to 75% (sometime 85%) of the loss that the lender would otherwise sustain. In addition, lenders can sell the risk-free guarantee portion of the loan on a very healthy secondary market and make a nice profit, and in the end only have a 25% direct exposure.

Scott is right that it is the case that, in such a competitive market and in such a vibrant capital market, bad firms are not technically crowding out good firms. However, what the SBA is doing is helping a minuscule fraction of deserving small businesses compete against other small businesses in the same market. By giving a credit market advantage to some small businesses, the SBA ends up harming the competing small businesses.

My guess is that Scott just hasn't taken the time to look at the big picture or the fundamental economics. His arguments are about his own personal experiences, while I am interested in the policy and economic implications of the SBA programs.

Finally, I am not quite sure how to address Michelle's point. She criticizes me for being in some ivory tower but doesn't address any of my arguments. She does talk about how she feels about my points, but that's it. However, I would like to make her feel better about one thing. I am by no means on the side of big businesses. I never miss an opportunity to criticize federal subsidies to big businesses. And I am by no means against small businesses (a meaningless term by the way: By SBA standards, a firm that has fewer than 500 employees is a small business, which means that more than 99% of U.S. firms are small). Another thing that should make Michelle feel better is that by all accounts, small businesses are doing great. They are growing, prospering, having access to credit, and competing actively at on the world market (check out the SBA Office of Advocacy Web site). And they are doing it without help from the SBA.

Scott

De Rugy continues to ignore that more than half the SBA loans are never sold, so there is no opportunity for those lenders to make a profit that would offset the losses associated with a double-digit default rate.

Forty-thousand to 60,000 businesses a year that receive SBA loans may seem like a "minuscule fraction" to de Rugy, but I believe they remain an important part of our economy that would be denied access to capital without the SBA.

I actually agree with de Rugy. In the theoretical, perfect world of fundamental economics, the free market is king and government stifles business. Unfortunately for her, that world does not exist and never will. In the real world, the smaller the business and loan request, the less the access to capital, hence the need for the SBA. Furthermore, financial ratios and other analytical tools diminish in relevancy as the size of the companies being analyzed decreases.

Adam

My wife and I received an SBA loan to start our business a year ago. Without it, we could have opened our doors but only by private borrowing and giving up 50% of our idea. In addition, regarding taxpayers bailing out the default loans, this is grossly exaggerated. SBA loans have to be secured in collateral (in our case machinery), and a portion of the loan is used to buy insurance should it default. In my opinion, the SBA did help us, the little guy, and gave us the boost we needed to get ahead. Now we are opening four more locations and will be taking out loans from the same lender that gave us the SBA loan. Just as Scott said, the payoff was in helping our business "graduate." I appreciate De Rugy's comments, but from down here, it just doesn't work that way.

Pedro

The Small Business Administration is of little value. It gives loans to noncreditworthy businesses, shifting funds away from larger enterprises deserving of credit. Pro or con?

Unbelievable con.

Any major global player was, one day, a small outfit starving for cash to bring into reality all those plans and ideas supported by an intrinsic energy. Fortunately, no one is so single-centered regarding sustainability, profitability, or innovation processes.

Moreover, all those venture capitalists or private equities look for instant cash return, and thus do not provide enough support for sustainable growth.

Take the global credit crisis: If entrepreneurial business are subjected only to the sentiment of markets overall, it would be relatively weird to have bright ideas only when the present and future prospects were shining. By undercutting those foundations, all true elements of innovation in products, services, technology, and management style would be put at risk, on hold, waiting for signals of freedom.

Large enterprises have their own ways of capitalizing: private equity, short-term capital, sovereign funds, IPOs, alliances through competitors, or players from others sectors, etc.

If all those ways get unbearably stuck when a liquidity crisis strikes at the world economy, imagine the small players.

Blown up without mercy?

Pat O

I read about micro loans in undeveloped countries and how important they are for the people of those lands to find a way out of their poverty. Certainly the SBA and the U.S. economy are far from those needs and that primitive economic model, but in a sense we aren't. The value of those loans and the reason they were generated was to plant seeds within those economies where change might occur. I think that micro-businesses here in the U.S. are part of a dynamic that builds our economic experience. When seeds are planted, many do not germinate and grow strong, but they are more than offset by those that thrive. So the default rates and the other statistical data aren't the whole story, and are to be expected.

Is the SBA needed in the face of adequate available loans, those without guarantees? I think that it is. Today's economic experience isn't the same as that of 10 or 20 years ago, and what happens in the future isn't certain. We are likely to be heading into tightening credit markets even now, due to the subprime mess going on in housing. Government programs can't start and stop on a dime. If it were abolished, getting another similar project started again would be very difficult, and would likely miss the future opportunity to actually be of use, missing the business-credit cycle. So better to allow a currently less necessary SBA to go forward toward a day where it is more needed than to abolish it. Especially if the cost is low, or as others have suggested (I don't know), possibly operating at a modest profit.

I think of this as an economic insurance policy. We need to have those seeds of innovation continue to be planted, no matter what the current or future condition of the credit markets may be. Looking at the moment as a snapshot doesn't really serve our needs as a society.

John Damacy

I think that people would think differently about supporting the SBA when they see how the loans are used. From my experience, the majority aren't used for startups or small business expansion, but rather just as an alternative to a commercial mortgage to purchase a building (usually chosen because the lender makes more money selling them). A great many of the loans go to franchisees such as motels and gas stations that many would think of as being just extensions of Corporate America. I think all of these activities could continue without the SBA, just with lenders making far less money doing them.

Small Business Owner

This discussion hasn't focussed on the devastation the SBA loans can cause in the lives of the borrowers. Let's focus on the 16% default rate. I read a recent forum post (elsewhere) that described a situation where as part of the collateral for a $300,000 loan to open a restaurant, the lender put a $300,000 lien or mortgage on the borrower's residence that only had equity of $100,000 and also required the borrower's personal guarantee. The business failed--one of the 16% who do. After the SBA made good on its 75% guarantee to the bank lender, they required the lender to foreclose on the borrower's house. So the upshot of this is that the SBA approved a mortgage equal to about 200% of the house value, which pales in comparison to the subprime mortgages that are so much in the news these days. Even they limit their loans to the value of the house.

That 16% is equivalent to 1/6. That means that 1 out of 6 SBA borrowers probably ends up losing the home and is probably forced to declare bankruptcy. What a help for the small business owner.

Doesn't the SBA have any fiduciary responsibility to approve reasonable loans? A consumer-oriented lawyer probably has a case to be made.

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