Will The Real Sba Please Stand Up?
If Ronald Reagan seeks reelection and wins, the chances are good that during his second term a significant issue affecting small business is going to be raised, debated, and, perhaps, resolved for a time.
The issue involves the access of small companies to debt capital, and there are two main questions: Should the federal government play a role in making credit available to small companies, and, if so, what is the role?
It is not a new issue, but the last time it got a thorough airing was in 1953. The resolution reached then hasn't held up well over time, and, in any case, the world has changed in 30 years. So has what is known about the role small business plays in the scheme of things.
If small business was thought of as a good thing for the country 30 years ago, it was not considered crucial. Small business people opened shoe stores and car washes in the new shopping centers that accompanied the post-war suburban sprawl, but economic growth in the United States then was strictly the business of big business. "I thought what was good for the country was good for General Motors, and vice versa," said President Eisenhower's newly appointed defense secretary, Charles E. Wilson; Jimmy Ling was well along toward inventing the conglomerate, and America's largest corporations were busy transforming themselves into multinationals.
As small business was considered rather more important for its votes than for its economic impact, Congress resolved the small business credit issue facing it then by creating an agency, the Small Business Administration, that was more symbol than substance. Today, as the role of small businesses in the U.S. economy has become more important, and as that importance has been recognized, the inadequacy of that 30-year-old symbolic gesture is becoming painfully apparent. Not only did Congress in 1953 underestimate the resources the SBA would need, it never clearly defined what the agency was supposed to do.
Consider the cases of Taylor and Stutt.
In 1974, Elizabeth Taylor, not the actress, but a woman running a small St. Louis catering service, asked the SBA for a loan of $86,900 to start a restaurant. The agency turned her down, partly because an SBA official believed that she wouldn't have enough working capital. Three weeks later, though, after a review, the agency lent her $36,700, less than half the amount she had asked for, and Taylor opened the restaurant anyway. The SBA official had been right. Without adequate working capital, Taylor had to borrow another $32,000 the following year, but the business failed just the same. Taylor lost her savings, her home, and her health. "I can't tell you how it would have helped my life so much if they had never given me the damn money," she told reporters for the St. Louis Globe-Democrat. "All it did was ruin my life."
Brian and Sharon Stutt spent six months in 1978 applying for a $50,000 SBA loan to buy inventory for their nascent Houston appliance-retailing business. They had a novel business plan, very little equity, and no collateral. Finally, they abandoned the loan application and pushed on without the money. In 1982, their company, Warehouse Appliance Inc., recorded sales of $8.9 million and last year ranked fifth on INC.'s list of the 500 fastest-growing privately held businesses. "We could have really used that money," says Sharon Stutt. "We'd probably be a lot bigger today."
Taylor is angry because the SBA gave her the money, and the Stutts are angry because it didn't. The agency couldn't win, because the guidelines Congress drew up for it in 1953 made winning impossible and created a permanent ambiguity. On the one hand, Congress told the SBA to make loans only to businesses unable to acquire credit "on reasonable terms" from another source. (Both Taylor and the Stutts had been turned down by banks.) On the other hand, the SBA was only to lend when the chance of repayment was "reasonably" assured. (The banks weren't convinced they would get their money back from either venture.) The two conditions were frequently contradictory, and thus the SBA was born schizophrenic. It developed a dual personality, and in the first one it saw itself as a welfare agency.
Congress gave the SBA authority to make two kinds of loans, direct and guaranteed. Direct loans, as the name implies, involve taking money from the U.S. Treasury and handing it over to someone who wants to start a business or whose business needs capital to grow. The SBA uses direct loans when it is behaving as a welfare agency, and these loans have created problems for the agency and for loan applicants, successful and otherwise, that Congress perhaps should have anticipated, but didn't.
Consider the case of Luther Boykins, a black barber who applied for and got three direct loans totaling $100,000 from the SBA between February 1970 and April 1971. Boykins used the cash to open and operate a grocery store that failed six months after the last loan was made. Not only was he out of business, he now owed the U.S. government $79,183 in principal and interest.
If Boykins was going to succeed in the grocery business, he needed more than money. He needed advice about where to locate his store, how to buy inventory, how to price his products, how to keep business records, how much to pay his help, how much working capital to borrow. Other than the money, Boykins claims, the SBA gave him no help at all.
In 1981, in an ambitious, nine-part report on SBA lending, the St. Louis Globe-Democrat examined more than 14,000 direct loans (including Boykins') made by the SBA over nine years in 15 states and found that 42% of the loans had gone into default; 33% of the dollars lent were never repaid; and new loans were made to refinance earlier loans to keep the records looking good.
The Globe-Democrat series prompted a hearing by the Senate Small Business Committee in 1981 into the shortcomings of the direct loan program. After hearing from Boykins and other witnesses, Sen. John Danforth, (R-Mo.), a committee member, delivered an admonishing lecture to the SBA officials present. "The purpose of the direct loan program, or any assistance program for that matter," Danforth informed them, "is not to throw money on the streets. . . . It means taking the time to make intelligent loan decisions, providing counsel where needed, and even turning away prospective loan recipients when it simply does not make sense to make loans. That should not be too much to ask." Somehow Danforth had missed the whole point of the Globe-Democrat series and of the testimony given at the hearing, both of which had made plain that it is too much to ask.
More than a half-million new businesses are started annually in the United States, and a substantial number of them will need to borrow capital. Beyond this, who-knows-how-many businesses in the course of a year aren't started, because their loan requests are rejected. Danforth, presumably, would have the SBA employ an army of civil servants to examine each of these proposals and to counsel each of the would-be entrepreneurs.
Boykins charged that Congress was using the SBA's direct-loan program just to pacify blacks, which was closer to the truth than Danforth's appraisal. Boykins was wrong only in that blacks weren't the only group that Congress sought to pacify. From time to time, Congress has required the SBA to target loans to specific groups -- e.g., blacks, women, the handicapped, ski-lodge operators suffering from a snow drought -- whose favor lawmakers curried. They created new direct-loan categories even when it amounted to cutting the same old loan pie six ways instead of five. Corrected for inflation, the average direct loan made in 1980 was worth less than one-third the average direct loan made in 1954, the year the SBA opened for business. In 1966, during Lyndon Johnson's War on Poverty, the average direct loan amounted to only $13,608, not enough to provide any real help in starting a business or in keeping an existing one going.
Most Administrations, Republican and Democratic alike, have played along with Congress in maintaining the SBA as a thinly disguised welfare agency for small business. Was it only coincidence that in 1972, the year Richard Nixon campaigned for his second term, the number of SBA loans jumped 44.5% over 1971? Nixon later bragged that more than half of all SBA loans made during the agency's first 20 years had been made during his Administration. In 1980, Jimmy Carter's SBA administrator, A. Vernon Weaver, managed only a 6.8% increase over the number of loans made in 1979. Nevertheless, Weaver was still able to claim, as the election approached, that "1980 was truly a banner year for our agency." By way of proof, he pointed to new records for loans to women- and minority-owned businesses
If Congress was fooling itself, and thought it was fooling its constituents, it wasn't fooling the people in charge of running the SBA loan program. They understood what the priorities were. Until 1981, the agency's managers rated the performance of its loan officials by watching how closely each approached his preassigned quarterly loan quota. The emphasis was on moving the money out the door. When he worked in the SBA's New York office, Bernard Lump testified before the Senate Small Business Committee, a supervisor told him not to worry much about whether borrowers would be able to repay the money. "We call them loans," Lump said the supervisor told him, "but they're really just grants."
In its other personality, when it wasn't behaving as a welfare agency, the SBA tried -- with much more success -- to play a different kind of role through its guaranteed lending program. The idea, never terribly well explained in the original legislation, was that small-business borrowers were somehow at a disadvantage in the credit market. Without taking the time to discover how and why that was the case, Congress gave the SBA authority to guarantee repayment to a bank (or other lender) of up to 90% of the loan it made to a small company. The guarantee did not get the lending officer completely off the hook -- he still had some of his institution's own money at risk -- but it might, Congress hoped, give him just enough comfort to tip the balance of his decision toward the small-business applicant.
The actual effect of the SBA's guarantee on lending decisions apparently has turned out to be different from what was anticipated, but no less useful. Bankers say they have not, as a rule, used SBA loan guarantees to make riskier loans. Instead, they told researchers for the General Accounting Office, a watchdog arm of the Congress, that the SBA guarantee allows them to increase the size and extend the terms of the small business loans they make.
To a small-business borrower, terms are often the most important aspect of a loan. A business that can repay a $250,000 loan over six years may not have the cash flow required to repay the same loan in three years.
Most non-SBA bank loans (52%), the GAO survey found, matured in less than one year, whereas 74% of all SBA guaranteed loans carried maturities of six years or more. The average maturity for SBA-guaranteed loans was 6.3 years, compared to less than three years for comparably sized loans made without the guarantee. And, SBA guaranteed loans tended to be larger -- $118,000 -- contrasted to the average nonguaranteed loan of $60,000 among the banks surveyed.
The GAO's survey also challenges a widely held presumption that the SBA's loan guarantee program affects only a tiny proportion of small companies. The 15,359 businesses that used an SBA guarantee last year represent far less than 1% of the roughly 11 million small companies in the United States. But, the GAO notes, not all 11 million companies sought long-term bank credit last year. (Dun and Bradstreet records from 1979, cited by the GAO, indicate in fact that only 4.5 million companies in business then had ever applied for credit of any kind during their lifetimes.) So when the GAO measured SBA lending against all bank credit extended to small companies in recent years, it found that about 13% of small-business lending involved an SBA guarantee. Moreover, the GAO estimates that SBA guaranteed loans may account for as much as 40% of all long-term (six or more years) credit extended to small business.
In contrast to its direct-loan efforts, the SBA's loan guarantee program has been relatively, if not completely, scandal-free. From time to time, auditors find that some SBA official has approved a new loan guarantee for a bank to bail it out of an old loan that is about to go into default. By and large, however, because both parties to the guarantee (the bank and the government) assume some risk, one tends to keep the other honest.
What is most encouraging about the guarantee program is that it is getting better, not worse; more, not less, efficient, easier, not harder, to use.
When the guarantee program first started, loan applications took weeks, sometimes months, as SBA lending officials, preoccupied, perhaps, with direct-loan applications, processed the paperwork. Applicants could appeal negative decisions, even write to their representatives in Congress, and that would eat up still more weeks.
Some of that still happens today, but the SBA has, on the whole, streamlined the process by turning over most of the paperwork to the banks. Recently, the agency went so far as to entrust the whole approval and guarantee process to a few banks on an experimental basis. These "preferred lenders" have authority to approve a loan and apply the government's guarantee for up to 75% without ever consulting the SBA. Agency officials like to say that they are getting out of the retail end of the lending business.
The most spectacular advance in the state of the art of SBA lending, however, is almost invisible to the borrower.
You can't, for example, fault Lawrence and Sandra Miller for not caring very much where their money actually came from. All they knew at the time was that because Saratoga State Bank had approved the $200,000 loan application, they could construct a proper building for their going hardware, building supply, feed, and laundromat business in Encampment, Wyoming (population, 700).
That was in 1979, and today, the Millers report, Beaver Valley Inc. is doing well. If a customer has the time, there is always a hot cup of coffee for him and a spot near the wood stove. They mail their payments to the bank promptly every month, and it is no concern of the Millers' where the money goes after that. It might even come as a surprise to them that most of their monthly check doesn't stay in the North Platte Valley where the Millers live. But the money didn't orginate there, either.
Cash to build the Millers' store came from investors who bought shares in a Boston-based money-market mutual fund. The mutual fund invested some of that capital in a $180,000 government-backed security, which it purchased from broker-dealer E. F. Hutton. Hutton had acquired the government-guaranteed security it sold to the mutual fund from Saratoga State Bank, which had made the loan to the Millers.
The route the money took was complex. The Millers don't know who the mutual fund investors are, and you can assume that the investors have never heard of, let alone sipped coffee in, Beaver Valley. But the effect of all these separate voluntary transactions, made by profit-seeking individuals and institutions, was simple. Capital moved through a financial market from Boston to a small business in Encampment.
Until 1979, the whole thing would have been impossible. Today, the only extraordinary thing about the Millers' deal is that it was the first of its kind. Never before had a small company, lacking prospects for spectacular growth and profitability, achieved access to the same capital sources that big businesses and governments at every level have always borrowed from. A mutual fund financed the Beaver Valley loan, but it could just as easily have been a pension fund or an insurance company, a major bank or even a wealthy individual. This year, thousands of small businesses will get loans worth hundreds of millions of dollars through the same capital market that the Millers unwittingly used, but as far as most of the businesses are concerned, they will just be borrowing money from the bank.
The SBA took nearly 30 years to discover that the bank loans it guarantees for small companies can be turned into marketable securities, just like home-mortgage loans, and sold on the secondary market to the same kind of investors that buy other government-backed paper, primarily financial institutions managing large portfolios.
The development of the secondary market is probably the most significant contribution the SBA has made to small business capital formation in its three decades of bureaucratic life. At the same time, it is the least visible improvement. Jim Ramsey, a former investment banker and now the SBA employee who, with one assistant, oversees the operation of the secondary market from an office in Manhattan, complains that most people in the SBA's Washington D.C., headquarters and on the congressional small business committees don't understand what he does.
But people in the Office of Management and Budget understand very well what Ramsey does, and they and other economic officials in the Administration don't like it one bit -- which is why, if Ronald Reagan wins a second term, the two questions posed at the outset of this article are going to be raised. They are, you will recall:
* Should the federal government play a role in making credit available to small companies?
* If so, what is the role?
Administration critics have one real, and one ideological, objection to the SBA's loan guarantee and secondary-market program. The real objection springs from what you might call the green-eyeshade mentality that infects the OMB or any other office employing lots of bookkeepers, auditors, and accountants. Every time the SBA stamps its guarantee on a loan, it creates a potential financial liability against the federal government. Never mind that, barring widespread economic catastrophe, most (about 95%) of those liabilities will never materialize. In the accountant's mind, they just don't look neat on the books.
The other objection, the ideological one, is more serious. It asserts that SBA loan guarantees amount to government interference in the credit market. Murray Weidenbaum, the first chairman of Reagan's Council of Economic Advisors, argued in an essay written for INC. in early 1981 (March, page 20) that "the small business sector would be a great deal healthier without [SBA loans and loan guarantees]." These loans, Weidenbaum explained, are simply the government's way of taking capital from one group of companies -- those to whom the "free market" would award the credit -- and handing it over to another group -- those whom the "free market" would exclude. Weidenbaum, and others still in the Administration, suggest that small companies would be far better off giving up their special loan programs and letting the free market work its will.
"I really admire their pristine views," says Pat Cloherty, an investment banker in New York City, "but I don't understand them. Markets are shot through with interventions. What do they think tax incentives are?" Her point, of course, is that SBA loan guarantees are not the only example of government meddling in the market, and that giving them up won't make the market free. Still remaining will be laws and regulations that, among other things restrict the size and cumulative amount of loans banks can make to small, risky companies; and that keep pension funds, the largest pools of capital in the country, from lending directly to small business.
So the answer to the first question, Should the federal government play a role in making credit available to small business? is: Maybe not, but it already does in many ways, most of them negative.
But if that is not a very satisfying answer, suspend the first question for a moment and move on to the second -- If so, what is the role?
It is just possible that, given a little time and some support from Congress and the Administration, the SBA can work itself right out of a job by turning over its entire lending program -- the processing of applications, the loan guarantee, the secondary market, everything -- to the private sector.
Sometime early in this session of Congress, Rep. Andy Ireland (D-Fla.), a member of the House Small Business Committee and a former banker, will seriously consider proposing legislation that promises to almost remove the SBA from its own guaranteed-loan program. He won't discuss details until the legislative package is wrapped up, but Ireland's scheme will probably involve creating some form of private insurance to replace the SBA guarantee now attached to small business bank loans. The government will play a reinsurance role, in effect backing up the private insurer so that these loans can still attract buyers among risk-averse investors in the secondary market.
The idea is not so radical as it might appear. Wisconsin banker Dean Treptow is already doing with private insurance what he used to do with the SBA guarantee, and in Treptow's arrangement the government is out of the picture entirely.
Treptow, president of Brown Deer Bank in the suburbs of Milwaukee, stopped making SBA guaranteed loans nearly two years ago. Now he takes each loan that would have gone into the SBA program and places it with other, similar loans in a pool. He insures the pool through a correspondent bank at premium rates that are based on the correspondent bank's evaluation of the risk. Then Treptow sells the insured pool of loans to his own bank holding company, which pays for the pool by issuing commercial paper in its own name.
In effect, outside investors, such as other banks and mutual funds, finance the loans that Brown Deer Bank makes to its small business customers. The system, Treptow says, needs some refining, but he sees no reason why it won't work for other banks just as it has worked for his. The benefits for the bank and for its borrowers are virtually the same as they would get from using SBA guaranteed loans, he says, but the government, and its paperwork, are out of the picture.
So maybe Treptow has the answer to the second question -- If so, what is that role? "The SBA," he suggests, "could provide a wonderful service. It could set up a system like this one nationally, show the private sector how it works, and then go out of business forever."
Maybe it could, but it may never get the chance to try. In its federal budget projections, the OMB has already all but written the SBA out of existence, reducing its loan budget from $3.6 billion this year to just $1 billion by 1987 -- enough to ensure its continuation as a symbolic welfare agency, but probably not enough to launch the kind of credit-market reform that Ireland and Treptow have in mind.
SBA administrator James Sanders would be happy for now if he could just persuade the OMB to endorse some technical changes in the law that would make the existing secondary market for SBA loan guarantees more efficient and attractive to institutional investors. But Sanders is the head of only one executive department agency that has never had much clout in the Washington power structure. He hasn't even been able to make his pitch to OMB director David Stockman. Stockman is busy looking for $200 billion to close the federal deficit, Sanders says. "They're so concerned with the big numbers, that I don't think they spend a lot of time with the small numbers we generate."