Small Business Administration: 7(a) Loan Program Needs Additional Performance Measures
Published: 2007-11-01T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Small Business Administration's (SBA) 7(a) program, initially established in 1953, provides loan guarantees to small businesses that cannot obtain credit in the conventional lending market. In fiscal year 2006, the program assisted more than 80,000 businesses with loan guarantees of nearly $14 billion. This testimony, based on a 2007 report, discusses (1) the 7(a) program's purpose and the performance measures SBA uses to assess the program's results; (2) evidence of any market constraints that may affect small businesses' access to credit in the conventional lending market; (3) the segments of the small business lending market that were served by 7(a) loans and the segments that were served by conventional loans; and (4) 7(a) program's credit subsidy costs and the factors that may cause uncertainty about these costs.
section_title: What GAO Found
paragraphs: As the 7(a) program's underlying statutes and legislative history suggest, the loan program's purpose is intended to help small businesses obtain credit. The 7(a) program's design reflects this legislative history, but the program's performance measures provide limited information about the impact of the loans on participating small businesses. As a result, the current performance measures do not indicate how well SBA is meeting its strategic goal of helping small businesses succeed. The agency is currently undertaking efforts to develop additional, outcome-based performance measures for the 7(a) program, but agency officials said that it was not clear when they might be introduced or what they might measure. Limited evidence from economic studies suggests that some small businesses may face constraints in accessing credit because of imperfections such as credit rationing, in the conventional lending market. Several studies GAO reviewed generally concluded that credit rationing was more likely to affect small businesses because lenders could face challenges in obtaining enough information on these businesses to assess their risk. However, the studies on credit rationing were limited, in part, because the literature relies on data from the early 1970s through the early 1990s, which do not account for recent trends in the small business lending market, such as the increasing use of credit scores. Though researchers have noted disparities in lending options among different races and genders, inconclusive evidence exists as to whether discrimination explains these differences. 7(a) loans went to certain segments of the small business lending market in higher proportions than conventional loans. For example, from 2001 to 2004 25 percent of 7(a) loans went to small business start-ups compared to an estimated 5 percent of conventional loan. More similar percentages of 7(a) and conventional loans went to other market segments; 22 percent of 7(a) loans went to women-owned firms in comparison to an estimated 16 percent of conventional loans. The characteristics of 7(a) and conventional loans differed in several key respects: 7(a) loans typically were larger and more likely to have variable rates, longer maturities, and higher interest rates. SBA's most recent reestimates of the credit subsidy costs for 7(a) loans made during fiscal years 1992 through 2004 indicate that, in general, the long-term costs of these loans would be lower than initially estimated. SBA makes its best initial estimate of the 7(a) program's credit subsidy costs and revises the estimate annually as new information becomes available. In fiscal years 2005 and 2006, SBA estimated that the credit subsidy cost of the 7(a) program would be equal to zero--that is, the program would no longer require annual appropriations of budget authority--by, in part, adjusting fees paid by lenders. However, the most recent reestimates, including those made since 2005, may change because of the inherent uncertainties of forecasting subsidy costs and the influence of economic conditions such as interest rates on several factors, including loan defaults and prepayment rates.

section_title: Letter
paragraphs: I am pleased to have the opportunity to be here today to discuss the Small  Business Administration’s (SBA) 7(a) loan program. Initially established in  1953, the 7(a) program guarantees loans made by commercial lenders— mostly banks—to small businesses for working capital and other general  business purposes. As the agency’s largest loan program for small  businesses, the 7(a) program is intended to help these businesses obtain  credit that they cannot secure in the conventional lending market. For  example, because they may lack the financial and other information that  larger, more established firms can provide, some small businesses may be  unable to obtain credit from conventional lenders. The guarantee provided  through the 7(a) program assures lenders that they will receive an agreed- upon portion (generally between 50 percent and 85 percent) of the  outstanding balance if a borrower defaults on a loan. Because the  guarantee covers a portion of the outstanding amount, lenders and SBA  share some of the risk associated with a potential default, decreasing the  lender’s risk and potentially making make more credit available to small  businesses. In fiscal year 2006, the 7(a) program assisted slightly more  than 80,000 businesses by guaranteeing loans valued at nearly $14 billion.
In my testimony, I will discuss the findings from our recent report on the  SBA’s 7(a) loan program. Specifically, my testimony addresses (1) the 7(a)  program’s purpose and the performance measures SBA uses to assess the  program’s results; (2) evidence of any market constraints that may affect  small businesses’ access to credit in the conventional lending market; (3)  the segments of the small business lending market that are served by 7(a)  loans and the segments that are served by conventional loans; and (4) the  7(a) program’s credit subsidy costs and the factors that may cause  uncertainty about the 7(a) program’s cost to the federal government.
In conducting this work, we reviewed the program’s underlying statutes  and legislative history. We compared the measures that SBA uses to assess  the performance of the 7(a) program to criteria that we developed for  successful performance measures and interviewed SBA officials on the  agency’s efforts to improve its performance measures. In addition, we  summarized peer-reviewed studies on market imperfections in the lending  market. Relying on SBA data from 2001 through 2004 and on the Federal  Reserve’s 2003 Survey of Small Business Finances (SSBF), we compared  characteristics and loan terms of 7(a) borrowers to those of small business  borrowers. Finally, we compared SBA’s original credit subsidy cost  estimates for fiscal years 1992 through 2006 to SBA’s current reestimates,  (as reported in the fiscal year 2008 Federal Credit Supplement) and  interviewed SBA officials about the differences. We conducted our work  in Washington, D.C., and Chicago between May 2006 and July 2007 in  accordance with generally accepted government auditing standards.
As the 7(a) program’s underlying statutes and legislative history suggest,  the loan program’s purpose is to help small businesses obtain credit. The  7(a) program’s design reflects this legislative history, but the performance  measures provide limited information about the impact of the loans on  participating small businesses. The underlying statutes and legislative  history of the 7(a) program help establish the federal government’s role in  assisting and protecting the interests of small businesses, especially those  with minority ownership. The program’s performance measures focus on  indicators that are primarily output measures—for instance, they report on  the number of loans approved and funded. But none of the measures looks  at how well firms do after receiving 7(a) loans, so no information is  available on outcomes. As a result, the current measures do not indicate  how well the agency is meeting its strategic goal of helping small  businesses succeed. The agency is currently undertaking efforts to develop  additional, outcome-based performance measures for the 7(a) program,  but agency officials said that it was not clear when these measures might  be introduced or what they might measure.
Limited evidence from economic studies suggests that some small  businesses may face constraints in accessing credit because of  imperfections such as credit rationing in the conventional lending market.  Some studies showed, for example, that lenders might lack the  information needed to distinguish between creditworthy and  noncreditworthy borrowers and thus could “ration” credit by not providing  loans to all creditworthy borrowers. Several studies we reviewed generally  concluded that credit rationing was more likely to affect small businesses,  because lenders could face challenges obtaining enough information on  these businesses to assess their risk. However, the studies on credit  rationing were limited because the researchers used different definitions  of credit rationing and the literature relied on data from the early 1970s  through the early 1990s. Data from this period does not account for recent  trends in the small business lending market, such as the increasing use of  credit scores, which may provide needed information and thus reduce  credit rationing. Though studies we reviewed noted some disparities  among borrowers with respect to race and gender in the conventional  lending market, the studies did not offer conclusive evidence on the  reasons for those differences.   7(a) loans went to certain segments of the small business lending market  in higher proportions than conventional loans from 2001 to 2004. First, a  higher percentage of 7(a) than conventional loans went to minority-owned  and start-up businesses. For example, 28 percent of 7(a) loans compared  with an estimated 9 percent of conventional loans went to minority-owned  small businesses from 2001 through 2004. In addition, 25 percent of 7(a)  loans went to small business start-ups, while the overall lending market  served almost exclusively established firms (about 95 percent). However,  more similar percentages of 7(a) and conventional loans went to other  segments of the small business lending market, such as women-owned  firms and those located in distressed neighborhoods. For example, 22  percent of 7(a) loans went to women-owned firms compared to an  estimated 16 percent of conventional loans. Finally, the characteristics of  7(a) and conventional loans differed in several key respects. In particular,  7(a) loans typically were larger and more likely to have variable rates,  longer maturities, and higher interest rates than conventional loans to  small businesses.
SBA’s current reestimates of the credit subsidy costs for 7(a) loans made  during fiscal years 1992 through 2004 indicate that, in general, the long- term costs of these loans will be lower than initially estimated. Loan  guarantee programs can result in subsidy costs to the federal government,  and the Federal Credit Reform Act of 1990 (FCRA) requires, among other  things, that agencies estimate the cost of the loan guarantees to the federal  government. SBA makes its best initial estimate of the 7(a) program’s  credit subsidy costs and revises the estimate annually as new information  becomes available. Starting in fiscal year 2005, SBA estimated that the  credit subsidy cost of the 7(a) program would be equal to zero—that is, the  program would no longer require annual appropriations of budget  authority. To offset some of the costs of the program, such as default  costs, SBA adjusted a fee paid annually by lenders that are based on the  outstanding portion of the guaranteed loan so that the initial credit subsidy  estimates would be zero (based on expected loan performance). However,  the most recent reestimates, including those made since 2005, may change.  Any changes would reflect the inherent uncertainties of forecasting  subsidy costs and the influence of economic conditions such as interest  rates on several factors, including loan defaults (which exert the most  influence over projected costs) and prepayment rates. Unemployment,  which related to the condition of the national economy, could also affect  the credit subsidy cost—for instance, if unemployment rises above  projected levels, loan defaults are likely to increase.
Our recent report made a recommendation to SBA that was intended to  help ensure that the 7(a) program was meeting its mission responsibility of  helping small firms succeed through guaranteed loans. Specifically, we  recommended that SBA complete and expand its current work on  evaluating the program’s performance measures and use the loan  performance information it already collects, including defaults and  prepayment rates, to better report how small businesses fare after they  participate in the 7(a) program. SBA concurred with the recommendation  but has not yet told us how the agency intends to implement it.
Finally, SBA disagreed with our analysis that showed limited differences in  credit scores between small businesses that accessed credit without SBA  assistance and those that received 7(a) loans. We believe that our analysis  of credit scores provides a reasonable basis for comparison. As SBA noted  in its comments, we disclosed the limitations of the analysis and noted the  need for some caution in interpreting the results. Taking into account  these limitations, we believe that future comparisons of comparable credit  score data for small business borrowers may provide SBA with a more  conclusive picture of the relative riskiness of 7(a) and conventional  borrowers, consistent with the intent of our recommendation.
subsections: section_title: Background
paragraphs: To be eligible for the 7(a) loan program, a business must be an operating  for-profit small firm (according to SBA’s size standards) located in the  United States. To determine whether a business qualifies as small for the  purposes of the 7(a) program, SBA uses size standards that it has  established for each industry. SBA relies on the lenders that process and  service 7(a) loans to ensure that borrowers meet the program’s eligibility  requirements. In addition, lenders must certify that small businesses meet  the “credit elsewhere” requirement. SBA does not extend credit to  businesses if the financial strength of the individual owners or the firm  itself is sufficient to provide or obtain all or part of the financing the firm  needs or if the business can access conventional credit. To certify  borrowers as having met the credit elsewhere requirement, lenders must  first determine that the firm’s owners are unable to provide the desired  funds from their personal resources. Second, lenders must determine that  the business cannot secure the desired credit for similar purposes and the  same period of time on reasonable terms and conditions from nonfederal  sources (lending institutions) without SBA assistance, taking into account  the prevailing rates and terms in the community or locale where the firm  conducts business.
According to SBA’s fiscal year 2003-2008 Strategic Plan, the agency’s  mission is to maintain and strengthen the nation’s economy by enabling  the establishment and viability of small businesses and by assisting in the  economic recovery of communities after disasters. SBA describes the 7(a)  program as contributing to an agencywide goal to “increase small business  success by bridging competitive opportunity gaps facing entrepreneurs.”  As reported annually in SBA’s Performance and Accountability Reports  (PAR), the 7(a) program contributes to this strategic goal by fulfilling each  of the following three long-term, agencywide objectives:  increasing the positive impact of SBA assistance on the number and  success of small business start-ups,   maximizing the sustainability and growth of existing small businesses that  receive SBA assistance, and   significantly increasing successful small business ownership within  segments of society that face special competitive opportunity gaps.
Groups facing these special competitive opportunity gaps include those  that SBA considers to own and control little productive capital and to have  limited opportunities for small business ownership (such as African  Americans, American Indians, Alaska Natives, Hispanics, Asians, and  women) and those that are in certain rural or low-income areas. For each  of its three long-term objectives, SBA collects and reports on the number  of loans approved, the number of loans funded (i.e., money that was  disbursed), and the number of firms assisted.
Loan guarantee programs can result in subsidy costs to the federal  government, and the Federal Credit Reform Act of 1990 (FCRA) requires,  among other things, that agencies estimate the cost of these programs— that is, the cost of the loan guarantee to the federal government. In  recognizing the difficulty of estimating credit subsidy costs and  acknowledging that the eventual cost of the program may deviate from  initial estimates, FCRA requires agencies to make annual revisions  (reestimates) of credit subsidy costs for each cohort of loans made during  a given fiscal year using new information about loan performance, revised  expectations for future economic conditions and loan performance, and  improvements in cash flow projection methods. These reestimates  represent additional costs or savings to the government and are recorded  in the budget. FCRA provides that reestimates that increase subsidy costs  (upward reestimates), when they occur, be funded separately with  permanent indefinite budget authority. In contrast, reestimates that  reduce subsidy costs (downward reestimates) are credited to the Treasury  and are unavailable to the agency. In addition, FCRA does not count  administrative expenses against the appropriation for credit subsidy costs.  Instead, administrative expenses are subject to separate appropriations  and are recorded each year as they are paid, rather than as loans are  originated.
section_title: The 7(a) Program’s Policy Objectives Reflect Legislative History, but Its Performance Measures Do Not Gauge the Program’s Impact on Participating Firms
paragraphs: The legislative basis for the 7(a) program recognizes that the conventional  lending market is the principal source of financing for small businesses  and that the loan assistance that SBA provides is intended to supplement  rather than compete with that market. The design of the 7(a) program has  SBA collaborating with the conventional market in identifying and  supplying credit to small businesses in need of assistance. Specifically, we  highlight three design features of the 7(a) program that help it address  concerns identified in its legislative history. First, the loan guarantee,  which plays the same role as collateral, limits the lender’s risk in  extending credit to a small firm. Second, the “credit elsewhere”  requirement is intended to provide some assurance that guaranteed loans  are offered only to firms that are unable to access credit on reasonable  terms and conditions in the conventional lending market. Third, an active  secondary market for the guaranteed portion of a 7(a) loan allows lenders  to sell the guaranteed portion of the loan to investors, providing additional  liquidity that lenders can use for additional loans.
Furthermore, numerous amendments to the Small Business Act and to the  7(a) program have laid the groundwork for broadening small business  ownership among certain groups, including veterans, handicapped  individuals, and women, as well as among persons from historically  disadvantaged groups, such as African Americans, Hispanic Americans,  Native Americans, and Asian Pacific Americans. The 7(a) program also  includes provisions for extending financial assistance to small businesses  that are located in urban or rural areas with high proportions of  unemployed or low-income individuals or that are owned by low-income  individuals. The program’s legislative history highlights its role in, among  other things, helping small businesses get started, allowing existing firms  to expand, and enabling small businesses to develop foreign markets for  their products and services.
All nine performance measures we reviewed provided information that  related to the 7(a) loan program’s core activity, which is to provide loan  guarantees to small businesses. In particular, the indicators all provided  the number of loans approved, loans funded, and firms assisted across the  subgroups of small businesses the 7(a) program was intended to assist.
We have stated in earlier work that a clear relationship should exist  between an agency’s long-term strategic goals and its program’s  performance measures. Outcome-based goals or measures showing a  program’s impact on those it serves should be included in an agency’s  performance plan whenever possible. However, all of the 7(a) program’s  performance measures are primarily output measures. SBA does not  collect any outcome-based information that discusses how well firms are  doing after receiving a 7(a) loan. Further, none of the measures link  directly to SBA’s long-term objectives. As a result, the performance  measures do not fully support SBA’s strategic goal of increasing the  success of small businesses by “bridging competitive opportunity gaps  facing entrepreneurs.”
SBA officials have recognized the importance of developing performance  measures that better assess the 7(a) program’s impact on the small firms  that receive the guaranteed loans. SBA is still awaiting a final report,  originally expected sometime during the summer of 2007, from the Urban  Institute, which has been contracted to undertake several evaluative  studies of various SBA programs, including 7(a), that provide financial  assistance to small businesses.
SBA officials explained that, for several reasons, no formal decision had  yet been made about how the agency might alter or enhance the current  set of performance measures to provide more outcome-based information  related to the 7(a) program. The reasons given included the agency’s  reevaluation of its current strategic plan in response to requirements in the  Government Performance and Results Act of 1993 that agencies reassess  their strategic plans every 3 years, a relatively new administrator who may  make changes to the agency’s performance measures and goals, and the  cost and legal constraints associated with the Urban Institute study.  However, SBA already collects information showing how firms are faring  after they obtain a guaranteed loan. In particular, SBA regularly collects  information on how well participating firms are meeting their loan  obligations. This information generally includes, among other things, the  number of firms that have defaulted on or prepaid their loans—data that  could serve as reasonable proxies for determining a firm’s financial status.  However, the agency primarily uses the data to estimate some of the costs  associated with the program and for internal reporting purposes, such as  monitoring participating lenders and analyzing its current loan portfolio.
Using this information to expand its performance measures could provide  SBA and others with helpful information about the financial status of firms  that have been assisted by the 7(a) program.
To better ensure that the 7(a) program is meeting its mission responsibility  of helping small firms succeed through guaranteed loans, we  recommended in our report that SBA complete and expand its current  work on evaluating the 7(a) program’s performance measures. As part of  this effort, we indicated that, at a minimum, SBA should further utilize the  loan performance information it already collects, including but not limited  to defaults, prepayments, and number of loans in good standing, to better  report how small businesses fare after they participate in the 7(a)  program. In its written response, SBA concurred with our  recommendation.
section_title: Limited Evidence Suggests That Certain Market Imperfections May Restrict Access to Credit for Some Small Businesses
paragraphs: We found limited information from economic studies that credit  constraints such as credit rationing could have some effect on small  businesses in the conventional lending market. Credit rationing, or  denying loans to creditworthy individuals and firms, generally stems from  lenders’ uncertainty or lack of information regarding a borrower’s ability  to repay debt. Economic reasoning suggests that there exists an interest  rate—that is, the price of a loan—beyond which banks will not lend, even  though there may be creditworthy borrowers willing to accept a higher  interest rate. Because the market interest rate will not climb high enough  to convince lenders to grant credit to these borrowers, these applicants  will be unable to access credit and will also be left out of the lending  market. Of the studies we identified that empirically looked for evidence  of this constraint within the conventional U.S. lending market, almost all  provided some evidence consistent with credit rationing. For example, one  study found evidence of credit rationing across all sizes of firms.  However, another study suggested that the effect of credit rationing on  small firms was likely small, and another study suggested that the impact  on the national economy was not likely to be significant.
Because the underlying reason for having been denied credit can be  difficult to determine, true credit rationing is difficult to measure. In some  studies we reviewed, we found that researchers used different definitions  of credit rationing, and we determined that a broader definition was more  likely to yield evidence of credit rationing than a narrower definition. For  example, one study defined a firm facing credit rationing if it had been  denied a loan or discouraged from applying for credit. However, another  study pointed out that firms could be denied credit for reasons other than  credit rationing—for instance, for not being creditworthy. Other studies  we reviewed that studied small business lending found evidence of credit  rationing by testing whether the circumstances of denial were consistent  with a “credit rationing” explanation such as a lack of information. Two  studies concluded that having a preexisting relationship with the lender  had a positive effect on the borrower’s chance of obtaining a loan. The  empirical evidence from another study suggested that lenders used  information accumulated over the duration of a financial relationship with  a borrower to define loan terms. This study’s results suggested that firms  with longer relationships received more favorable terms—for instance,  they were less likely to have to provide collateral. Because having a  relationship with a borrower would lead to the lender’s having more  information, the positive effect of a preexisting relationship is consistent  with the theory behind credit rationing.
However, the studies we reviewed regarding credit rationing used data  from the early 1970s through the early 1990s and thus did not account for  several recent trends that may have impacted, either positively or  negatively, the extent of credit rationing within the small business lending  market. These trends include, for example, the increasing use of credit  scores, changes to bankruptcy laws, and consolidation in the banking  industry.
Discrimination on the basis of race or gender may also cause lenders to  deny loans to potentially creditworthy firms. Discrimination would also  constitute a market imperfection, because lenders would be denying credit  for reasons other than interest rate or another risk associated with the  borrower. A 2003 survey of small businesses conducted by the Federal  Reserve examined differences in credit use among racial groups and  between genders. The survey found that 48 percent of small businesses  owned by African Americans and women and 52 percent of those owned  by Asians had some form of credit, while 61 percent of white- and  Hispanic-owned businesses had some form of credit. Studies have  attempted to determine whether such disparities are due to discrimination,  but the evidence from the studies we reviewed was inconclusive.
section_title: A Higher Percentage of 7(a) Loans Went to Certain Segments of the Small Business Lending Market, but Conventional Loans Were Widely Available
paragraphs: Certain segments of the small business lending market received a higher  share of 7(a) loans than of conventional loans between 2001 to 2004,  including minority-owned businesses and start-up firms. More than a  quarter of 7(a) loans went to small businesses with minority ownership,  compared with an estimated 9 percent of conventional loans (fig. 1).  However, in absolute numbers many more conventional loans went to the  segments of the small business lending market we could measure,  including minority-owned small businesses, than loans with 7(a)  guarantees.
Compared with conventional loans, a higher percentage of 7(a) loans went  to small new (that is, start-up) firms from 2001 through 2004 (fig. 2).  Specifically, 25 percent of 7(a) loans went to small business start-ups, in  contrast to an estimated 5 percent of conventional loans that went to  newer small businesses over the same period.
Only limited differences exist between the shares of 7(a) and conventional  loans that went to other types of small businesses from 2001 through 2004.  For example, 22 percent of all 7(a) loans went to small women-owned  firms, compared with an estimated 16 percent of conventional loans that  went to these firms. The percentages of loans going to firms owned equally  by men and women were also similar—17 percent of 7(a) loans and an  estimated 14 percent of conventional loans (fig. 3). However, these  percentages are small compared with those for small firms headed by men,  which captured most of the small business lending market from 2001 to  2004. These small businesses received 61 percent of 7(a) loans and an  estimated 70 percent of conventional loans.
Similarly, relatively equal shares of 7(a) and conventional loans reached  small businesses in economically distressed neighborhoods (i.e., zip code  areas) from 2001 through 2004—14 percent of 7(a) loans and an estimated  10 percent of conventional loans. SBA does not specifically report  whether a firm uses its 7(a) loan in an economically distressed  neighborhood but does track loans that go to firms located in areas it  considers “underserved” by the conventional lending market. SBA’s own  analysis found that 49 percent of 7(a) loans approved and disbursed in  fiscal year 2006 went to these geographic areas.
A higher proportion of 7(a) loans (57 percent) went to smaller firms (that  is, firms with up to five employees), compared with an estimated 42  percent of conventional loans. As the number of employees increased,  differences in the proportions of 7(a) and conventional loans to firms with  similar numbers of employees decreased. Also, similar proportions of 7(a)  and conventional loans went to small businesses with different types of  organizational structures and in different geographic locations.
Our analysis of information on the credit scores of small businesses that  accessed credit without SBA assistance showed only limited differences  between these credit scores and those of small firms that received 7(a)  loans. As reported in a database developed by two private business  research and information providers, The Dun & Bradstreet Corporation  and Fair Isaac Corporation (D&B/FIC), the credit scores we compared are  typically used to predict the likelihood that a borrower, in this case a small  business, will repay a loan. In our comparison of firms that received 7(a)  loans and those that received conventional credit, we found that for any  particular credit score band (e.g., 160 to <170) the differences were no  greater than 5 percentage points.  The average difference for these credit  score bands was 1.7 percentage points (fig. 4). More credit scores for 7(a)  borrowers were concentrated in the lowest (i.e., more risky) bands  compared with general borrowers, but most firms in both the 7(a) and the  D&B/FIC portfolios had credit scores in the same range (from 170 to  <200). Finally, the percentage of firms that had credit scores in excess of  210 was less than 1 percent for both groups.
The results our analysis of credit scores should be interpreted with some  caution. First, the time periods for the two sets of credit scores are  different. Initial credit scores for businesses receiving 7(a) loans in our  analysis are from 2003 to 2006. The scores developed by D&B/FIC for  small businesses receiving conventional credit are based on data from  1996 through 2000 that include information on outstanding loans that may  have originated during or many years before that period. Second,  D&B/FIC’s scores for small businesses receiving conventional loans may  not be representative of the population of small businesses. Although  D&B/FIC combined hundreds of thousands of financial records from many  lenders and various loan products with consumer credit data for their  credit score development sample, they explained that the sample was not  statistically representative of all small businesses.
Another score developed by D&B, called the Financial Stress Score (FSS),  gauges the likelihood that a firm will experience financial stress—for  example, that it will go out of business. SBA officials said that based on  analyses of these scores, the difference in the repayment risk of lending  associated with 7(a) loans was higher than the risk posed by small firms  able to access credit in the conventional lending market. According to an  analysis D&B performed based on these scores, 32 percent of 7(a) firms  showed a moderate to high risk of ceasing operations with unpaid  obligations in 2006, while only 17 percent of general small businesses had  a similar risk profile.
As already mentioned, SBA disagreed with the results of our credit score  comparison. In its written comments to our prior report, SBA primarily  reiterated the cautions included in our report and stated that the riskiness  of a portfolio was determined by the distribution in the riskier credit score  categories. SBA said that it had not worked out the numbers but had  concluded that the impact on loan defaults of the higher share of 7(a)  loans in these categories would not be insignificant. Although SBA  disagreed with our results, we believe that our analysis of credit scores  provides a reasonable basis for comparison. Specifically, the data we used  were derived from a very large sample of financial transactions and  consumer credit data and reflected the broadest and most recent  information readily available to us on small business credit scores in the  conventional lending market. As SBA noted in its comments, we disclosed  the data limitations and necessary cautions to interpreting the credit score  comparison. Taking into consideration the limitations associated with our  analysis, future comparisons of comparable credit score data for small  business borrowers may provide SBA with a more conclusive picture of  the relative riskiness of borrowers with 7(a) and conventional loans,  which would also be consistent with the intent of our recommendation  that SBA develop more outcome-based performance measures.
We also compared some of the characteristics of 7(a) and conventional  loans, including the size of the loans. In the smallest loan categories (less  than $50,000), a higher percentage of total conventional loans went to  small businesses—53 percent, compared with 39 percent of 7(a) loans.  Conversely, a greater percentage of 7(a) loans than conventional loans  were for large dollar amounts. For example, 61 percent of the number of  7(a) loans had dollar amounts in the range of more than $50,000 to   $2 million (the maximum 7(a) loan amount), compared with an estimated  44 percent of conventional loans (fig. 5).
Further, almost all 7(a) loans had variable interest rates and maturities  that tended to exceed those for conventional loans. Nearly 90 percent of  7(a) loans had variable rates compared with an estimated 43 percent of  conventional loans, and almost 80 percent of 7(a) loans had maturities of  more than 5 years, compared with an estimated 17 percent of conventional  loans (fig. 6).
For loans under $1 million, interest rates were generally higher for 7(a)  loans than for conventional loans. From 2001 through 2004, quarterly  interest rates for the 7(a) program were, on average, an estimated 1.8  percentage points higher than interest rates for conventional loans (fig.  7). Interest rates for small business loans offered in the conventional  market tracked the prime rate closely and were, on average, an estimated  0.4 percentage points higher. Because the maximum interest rate allowed  by the 7(a) program was the prime rate plus 2.25 percent or more, over the  period the quarterly interest rate for 7(a) loans, on average, exceeded the  prime rate.
section_title: Current Reestimates Show Lower-Than- Expected Subsidy Costs, but Final Costs May be Higher or Lower for Several Reasons
paragraphs: The current reestimated credit subsidy costs of 7(a) loans made during  fiscal years 1992 through 2004 generally are lower than the original  estimates, which are made at least a year before any loans are made for a  given fiscal year. Loan guarantees can result in subsidy costs to the federal  government, and the Federal Credit Reform Act of 1990 (FCRA) requires,  among other things, that agencies estimate the cost of the loan guarantees  to the federal government and revise its estimates (reestimate) those costs  annually as new information becomes available. The credit subsidy cost is  often expressed as a percentage of loan amounts—that is, a credit subsidy  rate of 1 percent indicates a subsidy cost of $1 for each $100 of loans. As  we have seen, the original credit subsidy cost that SBA estimated for fiscal  years 2005 and 2006 was zero, making the 7(a) program a “zero credit  subsidy” program—that is, the program no longer required annual  appropriations of budget authority. For loans made in fiscal years 2005  and 2006, SBA adjusted the ongoing servicing fee that it charges  participating lenders so that the initial subsidy estimate would be zero  based on expected loan performance at that time. Although the federal  budget recognizes costs as loans are made and adjusts them throughout  the lives of the loans, the ultimate cost to taxpayers is certain only when  none of the loans in a cohort remain outstanding and the agency makes a  final, closing reestimate. In addition to the subsidy costs, SBA incurs  administrative expenses for operating the loan guarantee program, though  these costs are appropriated separately from those for the credit subsidy.  In its fiscal year 2007 budget request, SBA requested nearly $80 million to  cover administrative costs associated with the 7(a) program.
Any forecasts of the expected costs of a loan guarantee program such as  7(a) are subject to change, since the forecasts are unlikely to include all  the changes in the factors that can influence the estimates. In part, the  estimates are based on predictions about borrowers’ behavior—how many  borrowers will pay early or late or default on their loans and at what point  in time. According to SBA officials, loan defaults are the factor that exerts  the most influence on the 7(a) credit subsidy cost estimates and are  themselves influenced by various economic factors, such as the prevailing  interest rates. Since the 7(a) program primarily provides variable rate  loans, changes in the prevailing interest rates would result in higher or  lower loan payments, affecting borrowers’ ability to pay and subsequently  influencing default and prepayment rates. For example, if the prevailing  interest rates fall, more firms could prepay their loans to take advantage of  lower interest rates, resulting in fewer fees for SBA. Loan defaults could  also be affected by changes in the national or a regional economy.  Generally, as economic conditions worsen—for example, as  unemployment rises—loan defaults increase. To the extent that SBA  cannot anticipate these changes in the initial estimates, it would include  them in the reestimates.
Mr. Chairman, this concludes my prepared statement. I would be pleased  to respond to any questions that you or other members of the  Subcommittee may have.
section_title: Contacts and Staff Acknowledgments
paragraphs: For additional information about this testimony, please contact William B.  Shear at (202) 512-8678 or Shearw@gao.gov. Contact points for our Offices  of Congressional Affairs and Public Affairs may be found on the last page  of this statement. Individuals making key contributions to this testimony  included Benjamin Bolitzer, Emily Chalmers, Tania Calhoun, Daniel  Garcia-Diaz, Lisa Mirel, and Mijo Vodopic.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. The published product may be reproduced and distributed in its entirety  without further permission from GAO. However, because this work may contain  copyrighted images or other material, permission from the copyright holder may be  necessary if you wish to reproduce this material separately.