u.s. SMALL BUSINESS ADMINISTRATION 

OFFICE OF INSPECTOR GENERAL 

ADVISORY MEMORANDUM 

REPORT No. 12-18 

DATE: AUGUST 16, 2012 

To: John A. Miller 

Director, Office of Financial Program Operations 

SUBJECT: A Detailed Repayment Ability Analysis is Needed on High-Dollar Early-Defaulted Loans to 

Prevent Future Improper Payments 

Summary 

In March 2012, our office issued Report No. 12-11R, High-Dol/or Early-Defaulted Loans Require an 

Increased Degree ofScrutiny and Improved Quality Control at the National Guaranty Purchase Center. 

In that report, we identified a concern regarding the National Guaranty Purchase Center's (NGPC) 

assessment of the quality and accuracy of lender underwriting. Specifically, we noted our concern that 

the NGPC's limited review of lender underwriting, including repayment ability analysis, was not 

consistent with statutory and regulatory authority and was contrary to SBA procedures. As follow-on to 

that report, we conducted a limited scope audit of the Small Business Administration's (SBA or the 

Agency) analysis of repayment ability during guaranty purchase reviews at the NGPC. In summary, this 

audit found that the assessment of delegated lender underwriting performed at the NGPC on earlydefaulted loans was not effective in identifying whether lenders were clearly negligent in determining 

the borrowers' repayment ability. Based on previous audit work, our analysis indicated that improved 

reviews for repayment ability could result in a cost savings to the SBA of at least $43 million over the 

next two years. 

The objective of the audit was to determine why adequate reviews of repayment ability were not being 

performed and the amount of federal funds that could be saved if the SBA thoroughly reviewed 

repayment ability during the guaranty purchase review of early-defaulted loans.l In meeting the 

objective, we reviewed repayment ability deficiencies identified during various Office of Inspector 

General (OIG) audits conducted from January 2008 to June 2012. 2 We also reviewed information in the 

SBA's Loan Accounting System. Furthermore, we interviewed SBA management officials and current 

and former SBA loan specialists to gain an understanding of the history and type of repayment ability 

1 Standard Operating Procedure (SOP) 50513, Loan Liquidation, defines early-defaulted loans as those loans that default within 

18 months of initial disbursement of the proceeds from an SBA loan. If the final disbursement occurs more than six months 

after initial disbursement, the 18-month period begins from the date of the final disbursement. 

2 We performed fieldwork for these audits between January 2008 and June 2012. OIG Report 9-16, The Small Business 

Administration's Fiscal Year 2008 Improper Payment Ratefor the 7(a) Guaranty Loan Program, July 10, 2009; OIG Report 9-18, 

SBA's Management of the Backlog of Post-Purchase Reviews at the National Guaranty Purchase Center, August 25,2009; OIG 

Report ROM 10-19, Material Deficiencies Identified in Early-Defaulted and Early-Problem Recovery Act Loans, September 24, 

2010; OIG Report ROM 11-06, Material Deficiencies Identified in Five 7(a) Recovery Act Loans Resulted in $2.7 Million of 

Questioned Costs, August 22, 2011; Project 11008, Audit ofSBA's FY 2011 Improper Payment Rate. 
analyses conducted during purchase reviews at the SBA. We also held a meeting with representatives 

from SBA's lending community and conducted research on the oversight of lender underwriting 

practices performed by federal regulators from the Federal Deposit Insurance Corporation and other 

federal agencies with guaranteed loan programs. To assess the internal controls relevant to our 

objective, we examined the SBA's policies and procedures regarding loan origination, closing, and 

guaranty purchase. 

We conducted this audit between November 2011 and March 2012 in accordance with Generally 

Accepted Government Auditing Standards. Those standards require that we plan and perform the audit 

to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions 

based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for 

our findings and conclusions based on our audit objective. 

Background 

The SBA is authorized under Section 7(a) of the Small Business Ace to provide financial assistance to 

small businesses in the form of government-guaranteed loans. The SBA's 7(a) loans are made by 

participating lenders under an agreement to originate, service, and liquidate loans in accordance with 

SBA's rules and regulations and prudent lending standards. Some 7(a) loans are made by lenders using 

delegated authority, which undergo very limited review by the SBA prior to loan disbursement. 

Others are subject to more extensive underwriting and eligibility review and approval by the SBA before 

loan disbursement. When a loan goes into default, the SBA will conduct a review of the lender's actions 

on the loan to determine whether it is appropriate to pay the lender the guaranty (which SBA refers to 

as a guaranty IIpurchase"). Under SBA regulations,4 the SBA is released from liability on the guaranty, in 

whole or in part, if the lender fails to comply materially with any SBA loan program requirement or does 

not make, close, service or liquidate the loan in a prudent manner. 

The guaranty purchase review is SBA's primary control for ensuring lender compliance and preventing 

improper payments in the 7(a) Program. The Improper Payments Elimination and Recovery Act of 2010 

(IPERA),s defines improper payments as expenditures that either should not have been made or were 

made in incorrect amounts under statutory, contractual, administrative, or other legally applicable 

requirements. 

The Office of Management and Budget (OMB) guidance6 for the Improper Payments Information Act of 

2002 (IPIA) and IPERA require agencies to conduct improper payment reviews for all programs and 

activities susceptible to significant improper payments, and to annually report their improper payment 

results to the President and Congress. For those programs and activities susceptible to significant 

improper payments/ the guidance also requires agencies to take actions to reduce and recover8 

3 Public Law 85-536, as amended. 


413 Code of Federal Regulations (CFR) § 120.524. 


5 Public Law 111-204. The IPERA amends the Improper Payments Information Act of 2002 (IPIA). Even though IPERA amends 


IPIA, the authorizing legislation is still named IPIA. 

6 Memorandum M-11-16, Issuance of Revised Parts I and /I to Appendix Cof OMB Circular A-l23. 

7 The SSA 7(a) business loan program has been identified by OMS as susceptible to significant improper payments. 

8 For those programs and activities that have annual gross improper payment estimates that exceed $10 million. 

2 
improper payments. Improper payments in the guaranty purchase process arise when an SBA purchase 

reviewer fails to identify material lender deficiencies in the handling of an SBA guaranteed loan. 

During the audit of purchased 7(a) Recovery Act loans,9 we obtained evidence supporting the fact that 

the NGPC's purchase review process did not require loan specialists to scrutinize credit decisions made 

by lenders on early-defaulted loans. Specifically, for loans that defaulted early, loan specialists did not 

analyze the reasonableness of the lenders' underwriting, including lender assessment of borrower 

repayment ability. Furthermore, prior GIG audits10 have identified loans with repayment ability 

deficiencies that were improperly purchased by the SBA, resulting in questioned costs of approximately 

$4.5 million. 

The potential for future improper payments due to unidentified repayment ability deficiencies is of 

substantial concern given the recent statutory increase in loan limits and the $5 billion increase in the 

SBA's lending volume from Fiscal Year (FY) 2010 to FY 2011. Specifically, the Small Business Jobs Act of 

201011 increased the maximum 7(a) loan amount from $2 million to $5 million, which increased the 

maximum SBA guaranteed amount to $3.75 million.12 From FY 2010 to FY 2011, the volume of section 

7(a) loans approved by the SBA grew from 52,936 to 53,707, or 1.46 percent. However, the SBA's 

guaranteed share of these loans increased from $10.3 billion to $15.4 billion, or 50 percent. 

The average loan size in the SBA's portfolio is increasing. As the average loan amount increases, there is 

a risk that the average loan amount requested by lenders for purchase will also increase. Therefore, it is 

important to prevent similar repayment ability deficiencies from going undetected as the risk of loss to 

the SBA becomes even greater. 

Results 

SBA's Assessment of Lender Underwriting during the Purchase Review Process was Inconsistent with 

Its Own Regulations and Procedures and Improvements Could Provide the SBA the Opportunity to Put 

Funds to Better Use 

The assessment of delegated lender underwriting performed at the NGPC on early-defaulted loans was 

not effective in identifying whether lenders were clearly negligent in determining the borrowers' 

repayment ability. As a result, the NGPC made improper payments by inappropriately purchasing the 

SBA guaranties on early-defaulted loans that did not have repayment ability, which resulted in 

unnecessary losses to the Agency. Furthermore, based on previous audit work, our analysis indicated 

that improved reviews for repayment ability could result in a cost savings to the SBA of at least $43 

million over the next two years. 

9 	OIG Report No 12-11R, High-Dollar Early-Defaulted Loans Require an Increased Degree ofScrutiny and Improved Quality 

Control at the National Guaranty Purchase Center, March 23, 2012. 

10 See footnote number 2 on page 1. 

11 Public Law 111-240, Small Business Jobs Act of 2010, September 27,2010. 

12 	For loans approved from September 27, 2010 through December 31,2010, the maximum SBA guaranteed amount was 

$4,500,000 because of the temporary 90 percent SBA guaranty on eligible 7(a) loans established under the American 

Recovery and Reinvestment Act of 2009. 

3 
In accordance with IPERA, agencies are required to take actions to reduce improper payments. 

According to SBA regulations,13 the applicant must be creditworthy and loans must be so sound as to 

reasonably assure repayment. The SBA's own procedures14 state that, 

on SBA-guaranteed loans, the cash flow of the small business applicant is the primary source of 

repayment, not the liquidation of collateral. Thus, if the lender's financial analysis demonstrates 

that the small business applicant lacks reasonable assurance of repayment in a timely manner 

from the cash flow of the business, the loan request must be declined, regardless of the 

collateral available. 

According to SBA procedures for early-defaulted loans/5 during the purchase review, the SBA must 

review the lender's purchase package with the IIhighest degree of scrutiny." Also, the recommending 

official must determine whether the lender's failure to make or close the loan in accordance with SBA 

requirements or prudent lending practices allowed or contributed to the early default. If the SBA 

purchase review indicates that the lender's actions or omissions resulted in a loss to the SBA, the 

procedures provide that repair or denial of the guaranty is appropriate. These same procedures define a 

repair as a specific agreed-upon dollar amount between the SBA and a 7(a) lender, which represents the 

actual or anticipated loss, caused by the lender and is deducted from the SBA's guaranty payment. 

Furthermore, the procedures explain that a denial of the SBA's liability is justified when a lender's 

actions or omissions caused, or could cause a material, total, or near total loss on a loan. 

We determined that the NGPC did not adequately assess lender underwriting during purchase reviews 

based on interviews with current and former SBA and NGPC officials who managed the NGPC operations 

or had performed purchase reviews. Management at the NGPC required loan specialists to perform a 

superficial review of the lenders' credit memorandum, which did not allow them to determine whether 

early-defaulted loans approved under delegated authority had repayment ability. Specifically, according 

to SBA management and a NGPC document describing the purchase review process, the NGPC's 

assessment of creditworthiness was limited to verifying that the lender's credit memorandum included 

certain elements. 16 However, loan specialists were not expected to evaluate whether the financial 

analyses of repayment ability performed by the lenders actually demonstrated reasonable assurance of 

repayment from the cash flow of the business. This limited assessment was performed regardless of the 

loan amount and was inconsistent with SBA's procedures which call for lithe highest degree of scrutiny" 

on early-defaulted loans. As a result, the NGPC inappropriately purchased the SBA guaranties on earlydefaulted loans that did not have repayment ability and incurred unnecessary losses to the Agency. 

While this can occur regardless of the dollar amount, prior audits have identified the issue to be 

significant with high-dollar17 early-defaulted loans. 

Historically, high-dollar loans have much lower early-default rates than smaller loans.18 For example, 

since 2007, high-dollar loans accounted for just about 6 percent of all early-defaulted loans. 

13 13 CFR § 120.150. 


14 Standard Operating Procedure (SOP) 50 10 5(D), Lender and Development Company Loan Programs. 


15 SOP 50 51 3, Loan Liquidation. 


16 These elements include collateral, credit history, credit elsewhere, management, capitalization, and repayment ability. 


17 For the purposes of this report, high-dollar loans are defined as those loans that were approved for $500,000 or more. 


18 For the purposes of this report, smaller loans are defined as those loans that were approved for less than $500,000. 

4 
Nevertheless, these loans account for a significant portion of the guaranty amounts purchased by the 

SBA on early-defaulted loans. For example, since 2007, high-dollar loans accounted for approximately 

$469 million, or 48%, of the guaranty amounts purchased by the SBA on early-defaulted loans. 

As a result, when high-dollar loans default early, the SBA should consider them IIhigh-risk" and scrutinize 

the lenders' underwriting, including their repayment ability analyses. 

Since 2008, we have performed five audits19 that focused on the origination, closing, servicing, 

liquidation, or purchase actions on problem or defaulted 7(a) loans. During these audits, we reviewed 

21 high-dollar early-defaulted loans approved by lenders under delegated authority. We determined 

that 8 of these loans, or 38 percent, did not have repayment ability (see Appendix II for a summary of 

the deficiencies identified on these loans). Six20 of these eight loans were inappropriately purchased by 

the NGPC resulting in questioned costs of approximately $4.5 million. While the remaining two loans 

have not been purchased, they still represent inappropriate loan approvals by the lenders of 

approximately $1.5 million. In consideration of our findings on the six loans, the SBA was able to 

recover approximately $2 million on two loans. For the remaining four of the six loans purchased by the 

NGPC, either recovery efforts are still underway or the SBA did not seek recovery from the lenders due 

to extenuating circumstances (i.e. statute of limitations, lender out of business).21 

Based on our results, the credit memorandum reviews performed by the NGPC loan specialists were not 

effective to identify whether lenders were clearly negligent in determining the borrowers' repayment 

ability. Thus, SBA funds could be put to better use if loan specialists thoroughly analyzed repayment 

ability during the guaranty purchase reviews of high-dollar early-defaulted loans approved under 

delegated authority. We estimated that thorough reviews leading to repairs and denials made by the 

SBA-on high-dollar early-defaulted loans that lack repayment ability-could result in cost savings of at 

least $43 million (See Appendix I for additional information on the details of our analysis). 

Historically, the SBA has delegated the credit decisions to the lenders for loans approved under the 

SBA's Preferred Lenders Program (PLP)22 and had instructed its loan specialists to not second-guess 

lenders' credit decisions. This was evident from interviews we conducted with SBA management 

officials. Prior to centralizing the guaranty purchase process at the NGPC in 2004, purchase reviews 

occurred in the SBA's 70 district offices. 23 There was much inconsistency in the district office reviews, 

including how repayment ability was analyzed. The inconsistencies in the purchase review process 

continued after the centralization and until the NGPC underwent a business process re-engineering in 

2007, which included revisions to its guaranty purchase process. 

During this re-engineering process, the Office of Financial Assistance (OFA) instructed the NGPC to 

standardize its reviews of the lenders' credit memorandum (including repayment ability) on early19 See footnote number 2 on page 1. 

20 See Appendix II: High-Dollar Early-Defaulted Loans with Repayment Ability Deficiencies, loan numbers [Ex. 4] 

[Ex. 4] , [Ex. 4] , [Ex. 4] , [Ex. 4] , and [Ex. 4] . 

21 See Appendix II: High-Dollar Early-Defaulted Loans with Repayment Ability Deficiencies, loan numbers [Ex. 4] 

[Ex. 4] , [Ex. 4] , and [Ex. 4] . 

22 	Under the PLP, SBA authorizes experienced lenders to make SBA guaranteed loans, subject only to a brief eligibility review 

and assignment of a loan number by the SBA. In addition, PLP lenders are expected to handle servicing and liquidation of 

their SBA loans with limited involvement of the SBA. 

23 See SBA's Budget Request and Performance Plan, FY 2003 Congressional Submission. 

5 
defaulted loans. Specifically, the OFA directed the NGPC to review only the credit memorandum 

components and to not second-guess the lenders' credit decisions. An internal document developed in 

September 2011 and approved by NGPC management confirmed this directive and clarified the credit 

memorandum elements that would be evaluated for early-defaulted loans. These clarifications were 

still not sufficient for loan specialists to determine whether lenders were clearly negligent in 

determining the borrowers' repayment ability. We also found that loan specialists at the NGPC had not 

been trained to perform a detailed analysis of repayment ability. 

Conclusion 

The SBA will continue to incur unnecessary losses on early-defaulted loans if the NGPC does not 

implement a process to verify compliance with SBA repayment ability requirements. Additionally, until 

this change is made, the SBA will not be in full compliance with IPERA because it will not identify 

improper payments resulting from repayment ability deficiencies. We believe, at a minimum, an 

effective review for repayment ability on early-defaulted loans should include a thorough examination 

of the credit memorandum, and verification that: 

• 	 cash flow was calculated correctly (included appropriate adjustments and no material errors), 

• 	 projected revenues exceeded projected expenses, 

• 	 projections were adequately supported by reasonable assumptions, and 

• 	 historical figures used by lenders were supported by historic financial statements or tax 


transcripts for existing businesses. 


Furthermore, the NGPC purchase staff will require training to perform effective reviews for repayment 

ability and prevent future improper payments. We estimate that if the Agency implements 

Recommendations No.1 and No.2, which specifically address these issues, a cost savings of at least 

$43 million will be realized over the next two years. Finally, as this report focuses on the risk to the SBA 

for high-dollar early-defaulted loans, we believe it would also be beneficial for the SBA to perform 

detailed analyses of repayment ability for smaller lender-approved early-defaulted loans. 

Recommendations 

We recommend that the Director, Office of Financial Program Operations: 

1. 	 Direct the NGPC to revise its purchase process for high-dollar early-defaulted loans approved by 

lenders to verify compliance with SBA's repayment ability requirements, including the 

performance of a detailed analysis of the lenders' com putation of repayment ability. 

2. 	 Properly train NGPC purchase staff in the revised purchase process to perform effective analyses 

of lenders' repayment ability computations and verify compliance with SBA requirements. 

3. 	 Perform a risk assessment to determine if it is beneficial for purchase reviews of smaller (less 

than $500,000) lender-approved early-defaulted loans to include a detailed analysis of the 

lenders' computation of repayment ability. 

6 
Agency Comments and Office of Inspector General Response 

On June 21, 2012, we provided a draft of this memorandum to the SBA for comment. On July 24, 2012, 

the SBA provided written comments, which are summarized below and contained in their entirety in 

Appendix III. The SBA agreed or partially agreed with all of the recommendations and the SBA's 

comments, proposed actions, and actions taken were responsive to the recommendations. 

Management Comments 

Management stated that it is fully committed to eliminating improper payments from all SBA loan 

programs. Management cited its efforts to date to improve the quality of lender credit underwriting 

and the underwriting reviews performed at the NGPC, including enhanced training and quality control 

feedback. Management's response also stated that it has formed a working group to review its 

Standard Operating Procedures and determine whether additional clarity is needed for lenders and staff 

to apply consistent underwriting standards. Further, management's response recognized that cost 

savings will occur by looking more carefully at high-dollar early-defaulted loans, but cited its plan to 

determine the accuracy of the OIG's $43 million estimate. Finally, management stated that it did not 

agree that all eight cases cited by the OIG as examples of loans with repayment ability deficiencies 

warranted denial for credit analysis alone and had other factors warranting their denial. 

DIG Response 

We commend the Agency for recognizing the need to improve its reviews of lender underwriting on 

high-dollar early-defaulted loans and for its training efforts to date. The $43 million funds for better use 

estimate covers a two-year period and assumes both years' activities are largely comparable. 

This estimate was derived in coordination with our statisticians based on the results of two loans that 

the Agency agreed had material lender noncompliance with the SBA's repayment ability requirements. 

The statistically valid methodology used to reach this estimate is disclosed in Appendix I of this report. 

We agree that many of the other cases cited as examples in this report included additional material 

deficiencies that could also support denial of liability. However, we maintain that the repayment ability 

deficiencies noted for each example in Appendix II of this report demonstrates material noncompliance 

or gross negligence on behalf of the lender that alone support denial of the SBA's guaranty. 

Recommendation 1 

Direct the NGPC to revise its purchase process for high-dol/or early-defaulted loans approved by lenders 

to verify compliance with SBA's repayment ability requirements, including the performance of a detailed 

analysis of the lenders' computation ofrepayment ability. 

Management Comments 

The SBA partially agreed with our recommendation. Management stated that it is in the process of 

augmenting its purchase review process on high-dollar early-default loans to include identification of 

material deficiencies in a lender's analysis of repayment ability. Management also stated that it has 

made recent process improvements in this area by allocating additional review time for high-dollar 

early-default loans. Finally, management stated it will perform further analysis on the OIG's $43 million 

estimate of funds for better use to determine its accuracy. 

7 
DIG Response 

The SBA's comments are responsive to the recommendation. As discussed above, the $43 million funds 

for better use estimate covers a two-year period and assumes both years' activities are largely 

comparable. This estimate was derived in coordination with our statisticians using loans that the Agency 

agreed had material lender noncompliance with the SBA's repayment ability requirements. 

The statistically valid methodology used to reach this estimate is disclosed in Appendix I of this report. 

Recommendation 2 

Properly train NGPC purchase staffin the revised purchase process to perform effective analyses of 

lenders' repayment ability computations and verify compliance with SBA requirements. 

Management Comments 

The SBA agreed with our recommendation. Management stated that it will continue to train NGPC 

purchase staff in the revised purchase process to perform effective analyses of lender's repayment 

ability computations and verify compliance with SBA requirements. 

DIG Response 

The SBA's comments are responsive to the recommendation. 

Recommendation 3 

Perform a risk assessment to determine ifit is beneficial for purchase reviews ofsmaller (less than 

$500,000) lender-approved early-defaulted loans to include a detailed analysis of the lenders' 

computation ofrepayment ability. 

Management Comments 

The SBA agreed with our recommendation. Management stated a risk assessment will be performed to 

determine if it is beneficial for purchase reviews of other lender approved early-default loans to include 

a detailed analysis of the lender's computation of repayment ability. 

DIG Response 

The SBA's comments are responsive to the recommendation. 

Actions Required 

Please provide your management response for each recommendation on the attached SBA Forms 1824, 

Recommendation Action Sheet, within 30 days from the date of this report. Your responses should 

identify the specific action(s) taken or planned for each recommendation and the target date(s) for 

completion. 

8 
We appreciate the courtesies and cooperation of the Small Business Administration during this audit. 

If you have any questions concerning this report, please call me at (202) 205-7390 or Terry Settle, 

Director, Credit Programs Group at (703) 487-9940. 

*** 

/5/ original signed 

John K. Needham 

Assistant Inspector General for Auditing 

9 
Appendix I. Funds Be Put to Better Use 

Under the Inspector General Act of 1978, as amended,24 IIfunds be put to better use" is defined as funds 

that could be used more efficiently if management of an establishment took actions to implement and 

complete the recommended action. This includes costs not incurred by implementing recommended 

improvements related to the operations of the establishment, a contractor, or grantee. 

We used results from the 2008 Improper Payments (2008 IPIA) audit to establish an amount of funds 

that could be put to better use if the SBA thoroughly analyzed repayment ability during the guaranty 

purchase reviews of early-defaulted loans. This audit encompassed a full year of SBA purchases totaling 

13,022 loans for approximately $869 million.2s From these purchases, we identified a population of 139 

high-dollar early-defaulted loans26 with SBA guaranteed payment amounts totaling $94.2 million. 

We audited two of the 139 loans during the 2008 IPIA audit. We identified lender noncompliance with 

the SBA's repayment ability requirements on both of these loans. These two loans resulted in total 

improper payments of approximately $2 million. 

Using the audit population and results described above, our statistician calculated an estimate of the 

minimum improper payment rate in the population. The calculations performed by the statistician 

provided that if there were only two improper payments in the population of 139 transactions, it is 

extremely unlikely that both of them would be selected in a sample size of two. In fact, there was only a 

1-in-9,591 chance for that to occur. Using this information and a 95% confidence interval, the 

statistician then determined the number of loans within the population that had repayment ability 

deficiencies that resulted in improper payments. Specifically, they estimated the lower bound of a 

one-sided 95% confidence interval. As a result, we can be 95% confident that the improper payment 

rate was at least the estimated lower bound shown below. 

Based on the statistician's methodology, in terms of the number of loans, this bound was determined to 

be at least 22.3%, or 31, of the 139 loans. The methodology is based on a Hypergeometric probability 

density: 

where (~) is the number of combinations of sample size M from which two improper payments are 

selected. The second part of the numerator (1390

-M) is the number of combinations of 139-M proper 

payments from which none were selected in the sample. The lower bound of a one-side 95% confidence 

interval is the lowest M such that f(M) ~ 5%? Based on the above equation, f(31) ;:::: 4.85%. In terms 

24 5 USC App. 3. 


25 These loans were purchased between April 1, 2007 and March 31,2008. 


26 Loans approved by delegated lenders for $500,000 or more that defaulted within 18 months and were purchased at the 


NGPC. 

10 
of dollars, this bound was determined to be 22.8%, or $21.5 million27 of the $94.2 million in the 

population. 

As a result, we conclude with 95% confidence that there were at least 31 loans totaling approximately 

$21.5 million that lacked repayment ability and should not have been purchased by the NGPC. 

Projecting the $21.5 million over the next two years, we believe the SBA will realize a cost savings of at 

least $43 million (less any associated costs) if the NGPC revises its purchase process to include a detailed 

repayment ability analysis for high-dollar early-defaulted loans. 

27 This dollar amount was determined by including the 2 loans that were actually tested and conducting 1,000 simulation runs 

of 29 additional randomly selected improper payments and using the average total dollar amount. As a result, each 

simulation run had a total count of 31 improper payments and their total payment amount was divided by the total payment 

amount for the entire population of 139 loans. 

11 
Appendix II. High-Dollar Early-Defaulted Loans with Repayment Ability Deficiencies 

# 

Loan 

Number 

Borrower 

Name Deficiency Description Approved Amount 

Questioned 

Costs" 

Recoveries 

Made 

1 [Ex. 4] [Ex. 4] 

The lender based its cash 

flow on figures recorded 

under the accrual method of 

accountlng,andignoredthe 

impact of changes on the 

balance sheet. The lender 

did not take into 

consideration the increase in 

Accounts Receivable and 

increase in Accounts 

Payable. While the lender 

calculated a positive cash 

flow of $209,500, we 

conducted our own cash 

flow analysis using the Cash 

Flow Statement Method 

approach and determined 

the business had a negative 

cash flow of -$92,643. 

$560,000 $456,426 $0* 

2 [Ex. 4] [Ex. 4] 

The lender failed to 

adequately demonstrate 

repayment ability from a 

Cash Flow Statement as well 

as verify that the liquid 

assets of the borrowers were 

sufficient to initially service 

the SBA debt. 

$2,000,000 $1,464,279 $1,484,235* 

3 [Ex. 4] [Ex. 4] 

The lender inappropriately 

added back $209,000 of 

personal income and a 

partner's $29,000 

guaranteed payment without 

explanation. When we 

removed these items from 

the cash flow computation, 

the business did not 

demonstrate repayment 

ability. 

$1,345,000 $984,124 $0* 

12 
Appendix II. High-Dollar Early-Defaulted Loans with Repayment Ability Deficiencies 

# 

Loan 

Number 

Borrower 

Name Deficiency Description Approved Amount 

Questioned 

Costs" 

Recoveries 

Made 

4 [Ex. 4] [Ex. 4] 

The lender's cash flow 

analysis did not consider the 

impact the two affiliated 

businesses would have on 

the borrower's repayment 

ability. According to the 

lender's credit 

memorandum, these two 

businesses were not 

sufficient to cover the 

borrower's personal living 

expenses. 

$675,000 $506,250 $522,894* 

5 [Ex. 4] [Ex. 4] 

The historical and interim 

debt service coverage was 

inadequate. Repayment 

ability was based on 

projections without 

underlying reasonable 

assumptions. 

$1,115,900 $998,033 $0* 

6 [Ex. 4] [Ex. 4] 

The lender used projected 

cash flow for an existing 

business to show repayment 

ability, which historically had 

negative cash flow. The 

projections included a 149 

percent increase in sales that 

was not justified. 

$525,000 $79,622 $0* 

7 [Ex. 4] [Ex. 4] 

A CPA-prepared statement of 

cash flow included in the 

lender's loan file 

demonstrated that the 

borrower did not have 

repayment ability. It appears 

that the lender ignored the 

CPA-prepared statement and 

instead calculated 

repayment ability using the 

rule of thumb method. It 

was imprudent to ignore a 

professionally prepared 

statement and rely solely on 

a self-prepared rule of 

thumb computation to 

support loan approval. 

$976,000 $0­ $0 

13 
Appendix II. High-Dollar Early-Defaulted Loans with Repayment Ability Deficiencies 

# 

Loan 

Number 

Borrower 

Name Deficiency Description Approved Amount 

Questioned 

Costs" 

Recoveries 

Made 

8 [Ex. 4] [Ex. 4] 

The lender prepared both 

Uniform Credit Analysis 

(UCA) and rule of thumb 

cash flow statements. The 

UCA cash flow statement 

clearly reflected the 

borrower's inability to repay 

the loan, butthelender 

approved the loan relying on 

the rule of thumb cash flow 

method for which some of 

the relied-upon figures could 

not be verified. We also 

found that the lender did not 

consider an affiliate of the 

borrower in its cash flow 

computations. 

$500,000 $0­ $0 

Totals $7,696,900 $4,488,734 $2,007,129 

"Questioned costs identified by the GIG in various audits conducted from January 2008 to June 2012 (see footnote number 2 on page 1). 

'Six loans purchased by the SBA as of May 21, 2012. 

-The SBA had not purchased these loans at the completion of the previous audits. Therefore, the GIG did not report questioned costs on these 

two loans in the previous audit reports. 

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Appendix III. Management Comments 

u.s. SMALL BUSINESS ADMINISTRATION 

WASHINGTON, D.C. 20416 

MEMORANDUM 


July 24, 2012 


To: John Needham 

Assistant Inspector General for Auditing 

From: John A. Miller 

Director, Office of Financial Program Operations 

Subject: Response to Draft Advisory Memorandum on A Detailed Repayment Ability Analysis is 

needed on High-Dollar Early-Defaulted Loans to Prevent Future Improper Payments, 

Project No. 12002 

Thank you for the opportunity to review the draft memorandum. The report outlines the OIG's concerns 

regarding the National Guaranty Purchase Center's (NGPC) assessment ofthe quality and accuracy of 

delegated lender underwriting practices on high dollar early default loans. The report also contained an 

estimate ofthe amount of federal funds which could be saved ifthese underwriting practices were 

thoroughly reviewed. 

The Office of Financial Program Operations (OFPO) is fully committed to eliminate improper payments 

from all SBA loan programs. SBA enhanced its training for the lending industry to include additional 

emphasis on credit underwriting quality, and provided case examples of extremely poor credit analyses 

that warranted denial of liability. NGPC has been training staff in the areas of credit underwriting and 

commercial credit. In April ofthis year, SBA commercial underwriting experts conducted credit 

underwriting training sessions in the NGPC for loan specialists and supervisors. During May, NGPC 

conducted IPERA training for all guaranty purchase loan specialists and supervisors, with an emphasis on 

credit underwriting. SBA also recently procured commercial loan credit correspondence training courses 

for NGPC loan specialists and supervisors. Finally, OFPO conducts quality control feedback training for 

center staff, and is emphasizing the importance of high dollar early default loans. These focused efforts 

will continue as part of OF PO and NGPC's ongoing efforts to assist loan specialists in enhancing their 

knowledge and skills in identifying material deficiencies in all loan guaranty purchase reviews, including 

the area of credit underwriting. 

In addition, the Associate Administrator for the Office of Capital Access and the Directors ofthe Office 

of Credit Risk Management, Office of Financial Assistance, and OFPO have agreed to form a working 

group to review the sections ofthe SOP 50 105 to address repayment assessment to determine if more 

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clarity and direction is required for lenders and staff to consistently apply consistent underwriting 

standards. 

The report estimated SBA could save $43 million ifNGPC revises its guaranty purchase review process 

to include a detailed repayment ability analysis for high dollar early-defaulted loans. This estimate was 

derived by OIG's statistician, and is explained in the appendix to their report. While we agree that there 

will be savings by looking more carefully at high dollar early defaulted loans, we are going to have our 

statistician review OIG's analysis to determine the accuracy of the $43 million estimate. 

As noted above OFPO and NGPC have taken steps to identify and address material deficiencies in credit 

underwriting on early-defaulted loans. We believe it is vital to the continued success of SBA's lending 

programs that the deficiencies identified in this type of review be material to a loss incurred by SBA in 

order to warrant a denial of liability recommendation. Appendix II ofthe OIG's report contains 8 cases 

cited as examples ofloans with repayment ability deficiencies. We do not agree that all cases warranted 

denial for credit analysis alone. There were other factors as well. In at least one case, we denied liability 

for loan closing deficiencies, not credit analysis. 

Management's response to the recommendations contained in the report follows: 

1. 	 Direct the NGPC to revise its purchase process for high-dollar early-defaulted loans 

approved by lenders to verify compliance with SBA's repayment ability requirements, 

including a detailed analysis ofthe lender's computation ofrepayment ability. 

OFPO partially agrees, and is in the process of augmenting its purchase review process on high-dollar 

early default loans to include identification of material deficiencies in a lender's analysis of repayment 

ability. Recent process improvements have already been made, including allocating additional review 

time for high dollar early defaults. Also, SBA will conduct an analysis ofthe OIG's $43 million estimate 

of funds for better use. 

2. 	 Properly train NGPC purchase staffin the revised purchase process to perform effective 

analyses oflender's repayment ability computations and verify compliance with SBA 

requirements. 

OFPO agrees, and will continue to train NGPC purchase staff in the revised purchase process to perform 

effective analyses oflender's repayment ability computations and verify compliance with SBA 

requirements. 

3. 	 Perform a risk assessment to determine ifit is beneficial for purchase reviews ofother (less 

than $500,000) lender approved early-default loans to include a detailed analysis ofthe 

lender's computation ofrepayment ability. 

OFPO agrees, and will perform a risk assessment to determine if it is beneficial for purchase reviews of 

other (less than $500,000) lender approved early-default loans to include a detailed analysis ofthe 

lender's computation of repayment ability. 

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