Bill Gossett, a banker in South Carolina, had been working with a client on a Small Business Administration loan application for three months. The entrepreneur hoped to borrow $785,000 to open a fast-food franchise. Just to make sure all went smoothly, Gossett, who is president of Island Community Bank in Beaufort, decided to hand-deliver the application to the local SBA office on Jan. 7. What he found there shocked him. "They wouldn't accept the application," says Gossett. "They basically had a 'closed for business' sign in the window."

This was no fluke. In an e-mail sent out on the evening of Jan. 6, the SBA announced that 7(a) loans were going on indefinite "holiday." Through the program, the agency's most popular, the SBA backs loans for thousands of small businesses that have a hard time raising money through conventional means. The e-mail also announced that the SBA would return or discard any applications that hadn't been approved. The unprecedented shutdown was stunning given what the Bush administration likes to say about its relationship with small business. Speaking to a group of women entrepreneurs two days after the shutdown, the President himself said, "Make no mistake about it, the role of government is to create the architecture in which people are willing to take risk." That the government had placed in limbo more than 1,000 small-business loans for more than $500 million was not mentioned.

Elsewhere, however, reaction to the holiday ranged from disbelief to outrage. One banker interviewed described her bank as "in a quandry," while another speculated that some institutions might be so soured by the experience that they would drop 7(a) lending entirely. Members of Congress from both parties, caught off-guard by the announcement, wrote letters of protest to SBA administrator Hector Barreto. Sen. Olympia Snowe of Maine, the Republican who chairs the Senate's small-business committee, complained that she had not been forewarned of the shutdown as required by law. And in a statement to Inc., Sen. John Kerry of Massachusetts, who also serves on the committee, blasted the agency for "neglecting its commitment to the small businesses that badly need access to capital."

"That the SBA shut down its most important loan program is outrageous."

-Rep. Nydia Velazquez (D-N.Y.), member of the house small-business committee

The catalyst for the crisis turns out to have been a surge in applications in the final three months of 2003. In late December, the SBA announced that it intended to cut the maximum amount one could borrow by more than half, from $2 million to $750,000--effective Jan. 8. The agency has instituted this kind of cap before. In fact, for nearly half of 2003, banks could only approve 7(a) loans for $500,000 or less. Neither lenders nor borrowers like the lowered cap. Considering all of the paperwork, entrepreneurs feel they should be able to borrow more. Banks argue that larger loans tend to be more secure. They also note that larger loans generate larger fees, which in turn help both them and the SBA cover the costs of making smaller loans.

Establishing the Jan. 8 end date for large loans had an ironic effect. Intended to preserve rapidly depleting funds, the impending cap precipitated such a flood of applications that the program was in danger of running out of money. To keep it afloat, Barreto shut it down.

Around the nation, businesses that were close to finalizing loans were left empty- handed. In Blair, Neb., about 45 minutes north of Omaha, Jeff Ellis had been planning to borrow $985,000 for more than a year. He had raised the required 10% down payment and completed the form, which was 10 pages long with questions front and back. He planned to use the money to buy signage for his chain of gas station convenience stores, which switched their distribution contract from Phillips 66 to Shell. After Ellis's lender, Business Loan Express, notified him of the impending $750,000 cap, he rushed to submit the paperwork by the deadline. If he had gotten it approved a week earlier, he would have been fine. Now, he may be forced to operate two stores without any recognizable signage. "What really burns me up is that they went back on their word," Ellis says, referring to the premature deadline. "They just trash-canned our applications."

In defending the agency's actions, SBA spokeswoman Sue Hensley pins the blame on Congress. Since the start of the 2004 fiscal year on Oct. 1, she says, the SBA has had to operate on a series of smaller allocations, passed as continuing resolutions, while Congress haggled over the federal budget bill. "The continuing resolution is not a credit card we can run up now and pay later," she says. "We can't run the program without funds, and Congress appropriates the funds." Only when the agency receives its full budget allocation, she adds, can it respond to spikes in demand.

"The administration is neglecting its commitment to the small businesses that badly need access to capital."

-Sen. John Kerry (D.-Mass.), member of the small-business committee

Critics charge, however, that the SBA is still low-balling demand for the loans. "It seems like annually there is a problem trying to get the appropriate amount of money for the budget," says Byron Payne, senior vice president at Wells Fargo, which has a large SBA lending program.

The facts bear Payne out. For fiscal 2003, the Bush administration requested only enough funding to guarantee $4.85 billion in 7(a) loans, despite warnings from the lending industry that the program would need twice that amount. Indeed, the SBA backed more than 50,000 loans for a total of $7.8 billion that year, even with the lowered cap in place. (See chart on next page.)

For the current fiscal year, the SBA requested only enough money to guarantee $9.3 billion in loans. Bankers warned that demand would rise above $12 billion, but they were ignored. What bothers the lenders most is that the program could be expanded relatively cheaply. Because the loans are made by banks--and guaranteed by the SBA at between 75% to 85% of their value--the 7(a) budget would need only an additional $25 million to $100 million to drive $3 billion more to businesses.

Amid a full-blown public relations debacle, the SBA hurriedly asked the White House Office of Management and Budget to allocate $470 million in unused 7(a) guarantees from the previous budget year to jump-start the program. The lending holiday officially ended at noon on Jan. 14. Over the course of the next week, the SBA exhausted $390 million of the additional funds the OMB had awarded to it. On Jan. 22, Congress approved a new budget for the agency that would enable it to guarantee as much as $9.6 billion in 7(a) loans.

Still, the Bush administration's commitment to the program remains in doubt. The $750,000 cap stands. Banks had hoped to "piggyback" loans--a process under which a business can use the same property or equipment as collateral for more than one loan--to accommodate business owners who had their applications destroyed or returned during the holiday. But the SBA, which wants first rights to that collateral if the loan defaults, opted to ban piggybacking despite the extraordinary circumstances.

It's too soon to know what the fallout will be. Banks are begging for a signal from the agency that its actions will be more predictable. "We'd just like to see this settled," says Wells Fargo's Payne. "For some people, this is the only access they have to capital."

The SBA's Hensley promises that the SBA will monitor the loan volume closely through the end of 2004, and ask for a larger budget for the next fiscal year.

For entrepreneurs like David Williams, the future of the program is less important than the concrete consequences of the January holiday. The owner of the No Rulez Laundromat in Landover, Md., will probably never see the $913,000 he applied for in order to open a second location. Worse, if he can't raise capital elsewhere, he could lose the money he put down to secure the space he intended to move into. "Now I'm left to deal with the landlord and the construction workers," Williams says. "Who's going to get me my deposit back?"

More Loans, Less Money