Why Small Business Loans May Not Open Up Until 2012 - Banks Under Pressure

It seems that at least once a week, the lack of credit for small businesses is in the news. Senators and members of Congress bloviate and blather endlessly about it. They gripe about SBA not doing more (which it can't unless Congress gives them the authority). The president talks about it. The wealthiest and most successful Wall Street investment bank - Goldman Sachs - repents of it hundreds of millions paid to employees in bonuses after having taken $10 billion TARP money by pledging $500,000,000 to help small businesses (and if there was ever one institution that has no clue what it's like to be a small business owner, it is Goldman Sachs). The press writes about the lack of small business credit because it makes really good copy, it is an ongoing story, and unfortunately, very true. All very nice. But overall none of it is going to get the banks to increase their small business lending until the economy begins to show real improvement and the banks are comfortable that the risk levels for small business have substantially decreased.

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The Banks

Since the banks are where the rubber meets the road with small businesses, most of the blame falls on them. But they don't deserve nearly all the blame that they are getting. Granted, many banks got over-aggressive as the boom rolled along and made commercial real estate loans that might not have gotten made under more conservative credit guidelines or a not-so-strong economy. But the economy was strong. Business was good. The most important thing that a bank usually bases loan decisions on is business tax returns, and businesses were showing good growth and profits. So, a lot of those loans that look over-aggressive now might not have been at the time. But that was then and this is now. A lot of those small businesses that were dong well have faltered and either are behind on or cannot meet their loan payments. In many cases it is not necessarily the owner's fault because it could well be that he or she may have been doing an excellent job of managing their business, but suddenly customers that they were selling to have disappeared or are not buying as much. So the business owner can't make or keep up with their loan payments, and the bank is getting burned. That whole scenario is probably not completely the fault of either one, but it is happening now.

So now look at the big picture. Everyone knows about the collapse, brought about largely by the implosion in the sub-prime residential mortgage market. That was the first domino, and they just kept on falling. Then there was TARP; then TALF (although I'm not real sure where that went). The Federal Reserve pulled out stops that hardly anyone realized they had to keep liquidity in the banking system, and between the Fed and Congress which passed the TARP legislation, disaster was probably avoided. So now the economy has bottomed out and is beginning to show signs of life - in the big picture. But unemployment has grown for 23 straight months as of December 2009 to over 10%, and when people who can only find part-time work or have totally given up are counted, the number approaches 17%. Consumers account for about 70% of economic activity. So swinging all the way back around to the small business owner, many of their customers can no longer afford to buy, the business owner cannot make their mortgage payment, and the bank now has a non-performing asset on their books. And because bank examiners are cracking down on banks with non-performing assets, those banks are having to take money out of their capital and put it in loan loss reserves, meaning that it can't be used to make loans. That becomes very significant because depending on the strength of the bank, $1 in capital on the balance sheet can usually create anywhere from $5 to $10 in loans. So by making banks stronger in the long run, it is hurting small business credit in the short run because the banks don't have the funds to make as many loans.

One of Many Wildcards

One thing that might slow up the flow of credit to small business is more emphasis sound credit and underwriting policies buy banks. Almost universally, loan underwriting is based on a company's historical financial performance, which is taken from the business tax returns. The economic downturn started picking up speed in 2008. In 2009, the bottom fell out in many industries. 2010 is going to be a very slow recovery, and 2011 is not going to be much better; still improving, but not a lot. So many small businesses that have always been well-managed, paid their bills on times, have cut costs to stay in business, are likely to wind up with two or three years of business tax returns showing declining revenues and profits. Sound underwriting practice normally results in rejections of loan applications from companies with declining sales and profits. So the simple fact that even if more money is available, by whatever means the government might be able to create, many companies might not qualify for loans even if money is available.

So what might happen? That fact to me is one of the major wild cards in the economic recovery deck. If banks perceive that the economic growth is finally on a sound footing and is going to continue, then the prospects for small businesses, historically the riskiest borrowers, will improve. Yet at the same time, those businesses that are starting to grow again may have lousy earnings and balance sheets. So there is a dilemma for you to ponder.

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