Small Business Administration: Additional Guidance on Documenting Credit Elsewhere Decisions Could Improve 7(a) Program Oversight
Published: 2009-02-12T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Small Business Administration's (SBA) 7(a) program is intended to provide loan guarantees to small business borrowers who cannot obtain conventional credit at reasonable terms and do not have the personal resources to provide financing themselves. In fiscal year 2008, SBA guaranteed over 69,000 loans valued at about $13 billion. To assist in oversight of the 7(a) program, GAO was asked to (1) describe SBA's criteria and lenders' practices for determining that borrowers cannot obtain credit elsewhere and (2) examine SBA's efforts to ensure that lenders are complying with the credit elsewhere provision. To meet these objectives, GAO reviewed applicable statutes and guidance, visited 18 lenders and reviewed 238 of their loan files, reviewed 97 on-site lender review reports, and interviewed SBA officials. GAO's samples of lenders and loan files were not generalizable.
section_title: What GAO Found
paragraphs: The Small Business Act and 7(a) program regulations and guidance allow lenders to use their conventional lending practices to determine whether borrowers can obtain credit elsewhere at reasonable terms. On the basis of a review of 238 loan files at 18 lenders, GAO observed that the most common reasons these lenders cited to substantiate that borrowers could not obtain credit elsewhere were that the borrower needed a longer maturity than the lender's policy permitted and the borrower's collateral did not meet the lender's requirements. These factors are two of the six listed in SBA's guidance as acceptable to substantiate that a borrower could not obtain conventional credit. SBA has issued little guidance on how lenders should document in their files that borrowers could not obtain credit elsewhere. Internal control standards for federal agencies specify that good guidance (information and communication) is necessary to help ensure the proper implementation of program rules. While SBA's guidance requires lenders to explain why the borrower could not obtain credit elsewhere in the loan file, it does not specify what exactly lenders should include in their explanations. Between October 2006 and March 2008, SBA reviewed 97 lenders and determined that 31 of them had failed to consistently document that borrowers met the credit elsewhere requirement or personal resources test. All but one of the lenders with whom GAO met documented their credit elsewhere decisions in some way; however, given the broad authority granted to lenders, the explanations were generally not specific enough to reasonably support the lender's conclusion that borrowers could not obtain credit elsewhere. A number of these lenders used a checklist that simply listed the six acceptable reasons cited in SBA's guidance for substantiating that a borrower could not obtain credit elsewhere and did not prompt them to provide more information specific to the borrower--for example, details on insufficient collateral. Absent detailed guidance on what exactly SBA wants lenders to document in their credit elsewhere determinations, lenders likely will continue to offer limited information in their files, making meaningful oversight of compliance with the credit elsewhere requirement difficult.

section_title: Letter
paragraphs: The recent tightening of the credit markets has raised concerns about the  ability of small businesses to obtain credit and has increased attention on  alternative sources of credit for this segment of the economy. The Small  Business Administration (SBA) was created in 1953 to assist and protect  the interests of small businesses, in part by addressing constraints in the  supply of credit for these firms. The 7(a) program, named after the section  of the Small Business Act that authorized it, is SBA’s largest business loan  program. The program is intended to serve creditworthy small business  borrowers who cannot obtain credit through a conventional lender at  reasonable terms and do not have the personal resources to provide  financing themselves. In fiscal year 2008, SBA guaranteed over 69,000  loans valued at about $13 billion. The loan guarantee covers part of a  lender’s losses in the event of a default, reducing the risk of lending to  small businesses that would otherwise not qualify for a conventional loan.  To streamline the lending process, SBA works with lenders that have  “delegated authority”—that is, the ability to make credit determinations  without prior review by SBA. According to SBA, the majority of loans that  it guarantees each year are made by lenders with delegated authority.
Because the 7(a) program is intended to serve borrowers who cannot  obtain conventional credit at reasonable terms, lenders making 7(a) loans  must ensure that borrowers meet the “credit elsewhere” requirement. This  requirement stipulates that to receive 7(a) loans, borrowers must not be  able to obtain financing under reasonable terms and conditions from  conventional lenders. In addition, because 7(a) borrowers must not have  the personal resources to cover the needed funding, lenders also must  apply a “personal resources” test to confirm that the desired funds are not  available from any principal of the business. Lenders may reject a small  business’s application for a conventional loan for a variety of reasons. For  example, a business may need a loan with longer maturity than the  lender’s policy permits or an amount that exceeds the lender’s legal  lending limit or policy limit for a single customer. Lenders also may  require more collateral than a small business can offer or may not lend to  start-ups or firms in certain industries.
To assist you in overseeing the 7(a) program, you asked us to review how  lenders implement and SBA oversees the program’s credit elsewhere  provision. Specifically, this report (1) describes SBA’s criteria for  determining that borrowers cannot obtain credit elsewhere and practices  lenders employ to determine that borrowers cannot obtain credit  elsewhere and (2) examines SBA’s efforts to ensure that lenders are  complying with the credit elsewhere provision.
To address these objectives, we reviewed applicable statutes and the  legislative history of the 7(a) program, SBA’s regulations and guidance for  administering the program, our previous reports, and studies of the  program conducted by the SBA Inspector General and external  organizations. To determine lender practices for implementing the credit  elsewhere provision, we visited 18 lenders with delegated authority and  reviewed 238 of their approved applications for 7(a) loans. We selected  these lenders based on the size of their SBA loan portfolios and geography,  among other things. The number of files we reviewed at each lender was  based on the size of the lender’s portfolio; we reviewed more files at larger  lenders than we did at smaller lenders. While our samples of 18 lenders  and 238 loans files are nongeneralizable, they offer perspectives on how  some lenders implement the credit elsewhere provision. We interviewed  SBA officials and contractor staff to discuss lender oversight efforts and  reviewed all 97 on-site review reports completed between October 2006  and March 2008 and related correspondence and enforcement action data.  Appendix II discusses our scope and methodology in further detail.
We conducted our work in Atlanta, Georgia; Chicago, Illinois; Houston,  Texas; Los Angeles, California; New York City, New York; San Francisco,  California; and Washington, D.C., between February 2008 and February  2009 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 objectives.
subsections: section_title: Background
paragraphs: The Small Business Act created SBA to aid, counsel, assist, and protect the  interests of small business concerns. The first version of Section 7(a) of  the act empowered SBA to make loans to small businesses with the  restriction that “no financial assistance shall be extended … unless the  financial assistance applied for is not otherwise available on reasonable  terms.” While there have been numerous amendments to Section 7(a), the  credit elsewhere restriction has remained, with slight modifications. For  instance, the phrase “credit elsewhere” was introduced in 1981 and the  provision was changed to read that “o financial assistance shall be  extended pursuant to this subsection if the applicant can obtain credit  elsewhere.” At the same time, a definition of credit elsewhere was added.
The 7(a) program’s legislative history emphasizes the program’s role in  meeting the credit needs of certain small businesses. The legislative basis  for the 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. As the legislative history suggests, conventional  lending may not be a feasible financing option for some small businesses  under certain circumstances. The design of the 7(a) program is consistent  with the statute and its legislative history. First, the loan guarantee limits  the lender’s risk in extending credit to a small firm that may not have met  the lender’s own requirements for a conventional loan. 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 markets.  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.
Under the 7(a) program, SBA guarantees loans made by commercial  lenders to small businesses for working capital and other general business  purposes. These lenders are mostly banks, but some are nondepository  lenders, including small business lending companies (SBLC)— nondepository lenders previously chartered by SBA to provide 7(a) loans  to qualified small businesses. The guarantee assures the lender that if a  borrower defaults on a loan, the lender will receive an agreed-upon  portion (generally between 50 percent and 85 percent) of the outstanding  balance. For a majority of 7(a) loans, SBA relies on lenders with delegated  authority to process and service 7(a) loans and to ensure that borrowers  meet the program’s eligibility requirements. To be eligible for the 7(a)  program, a business must be an operating for-profit small firm (according  to SBA’s size standards) located in the United States and meet the credit  elsewhere requirement, including the personal resources test.
SBA is not authorized to 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 or if the business can access  conventional credit. To assess whether borrowers can obtain credit  elsewhere, lenders must determine that the desired credit, for a similar  purpose and period of time, is unavailable to the firm on reasonable terms  and conditions from nonfederal sources without SBA assistance, taking  into consideration prevailing rates and terms in the community or locale  where the firm conducts business. Nonfederal sources may include any  lending institutions. In addition, lenders must determine that the firm’s  owners are unable to provide the desired funds from their personal  resources. When applying this personal resources test, the lender must  assess the liquid assets of each owner of 20 percent or more of the equity  of the applicant company to determine the overall dollar value of the  allowable exemption, which is defined as the amount of personal  resources that do not have to be injected into the business. The allowable  exemption is determined on the basis of the “total financing package.” The  total financing package includes any SBA loans, together with any other  loans, equity injection, or business funds used or arranged for at the same  general time for the same project as the SBA loan. If the total financing  package  is $250,000 or less, the exemption is two times the total financing package  or $100,000, whichever is greater; is between $250,001 and $500,000, the exemption is one and one-half times  the total financing package or $500,000, whichever is greater; or   exceeds $500,000, the exemption equals the total financing package or  $750,000, whichever is greater.
Once the exemption is determined, it is subtracted from the liquid assets.  If the result is positive, that amount must be injected into the project.
When the 7(a) program was first implemented, borrowers were generally  required to show proof of credit denials (rejection documentation) from  no fewer than two banks that documented, among other things, the  reasons for not granting the desired credit. Similar requirements remained  in effect until 1985, when SBA amended the rule to permit a lender’s  certification made in its application for an SBA guarantee to be sufficient  documentation. This certification requirement remained when the rule  was rewritten in 1996. SBA stated that requiring proof of loan denials was  demoralizing to small businesses and unenforceable by SBA.
Within the 7(a) program, there are several delivery methods—including  regular 7(a), the preferred lender program (PLP), and SBAExpress. Under  the regular (nondelegated) 7(a) program, SBA makes the loan approval  decision, including the credit determination. Under PLP and SBAExpress,  SBA delegates to the lender the authority to make loan approval decisions,  including credit determinations, without prior review by SBA. The  maximum loan amount under the SBAExpress program is $350,000 (as  opposed to $2 million for other 7(a) loans). The program allows lenders to  utilize, to the maximum extent possible, their respective loan analyses,  procedures, and documentation. In return for the expanded authority and  autonomy provided by the program, SBAExpress lenders agree to accept a  maximum SBA guarantee of 50 percent. (Other 7(a) loans have a  maximum guarantee of 75 or 85 percent, depending on the loan amount.)  According to SBA, as of December 31, 2007, there were 672 PLP and 1,889  SBAExpress lenders. Of these, 603 lenders were approved for both  programs.
In the federal budget, the 7(a) program is currently a “zero subsidy”  program, meaning that the program does not require annual  appropriations of budget authority for new loan guarantees. To offset  some of the costs of the program, such as default costs, SBA assesses  lenders two fees on each 7(a) loan. The guarantee fee must be paid by the  lender at the time of loan application or within 90 days of the loan being  approved, depending upon the loan term. This fee is based on the amount  of the loan and the level of the guarantee, and lenders can pass the fee on  to the borrower. The ongoing servicing fee must be paid annually by the  lender and is based on the outstanding balance of the guaranteed portion  of the loan.
SBA’s Office of Credit Risk Management (OCRM) is responsible for  overseeing 7(a) lenders, including those with delegated authority. SBA  created this office in fiscal year 1999 to ensure consistent and appropriate  supervision of SBA’s lending partners. The office is responsible for  managing all activities regarding lender reviews, preparing written reports,  evaluating new programs, and recommending changes to existing  programs to assess risk potential.
section_title: Program Design Allows Lenders to Use Their Conventional Lending Policies to Make Credit Elsewhere Decisions
paragraphs: The Small Business Act and 7(a) program regulations give lenders  discretion to determine which borrowers cannot obtain credit elsewhere  and thus require an SBA guarantee. SBA’s primary guidance for the 7(a)  program outlines six reasons lenders can use to substantiate that a  borrower cannot obtain credit elsewhere. Together, the statute,  regulations, and guidance allow lenders to use their own conventional  lending policies to determine which borrowers need an SBA guarantee.  Our file reviews showed that lenders most often cited the borrower’s need  for a longer maturity, lack of collateral, and the age or type of business as  reasons for requiring an SBA guarantee.
subsections: section_title: SBA’s Credit Elsewhere Requirement Gives Broad Authority to Lenders
paragraphs: “the availability of credit from non-Federal sources on reasonable terms and  conditions taking into consideration the prevailing rates and terms in the  community in or near where the concern transacts business, or the  homeowner resides, for similar purposes and periods of time.”
Consistent with the statute, the governing regulations note that SBA will  guarantee loans only for applicants for whom the desired credit is not  otherwise available on reasonable terms from a nonfederal source.  According to SBA, the credit elsewhere requirement was specifically  designed to be broad in order not to limit lenders’ discretion and to allow  for differences in geographic regions, economic conditions, and types of  businesses.
SBA’s primary operational guidance for the 7(a) program—SOP 50-10— builds upon the statute and regulations by outlining six reasons lenders  can use to substantiate that a borrower cannot obtain credit elsewhere on  reasonable terms. These reasons can be divided into two groups: those  that are specific to the borrower’s creditworthiness or business and those  that are specific to the lender’s financial position and unrelated to a  borrower’s creditworthiness or the availability of loans from other  sources. Reasons related to the borrower are that    The business needs a longer maturity than the lender’s policy permits.
The collateral does not meet the requirements of the lender’s policies.
The lender’s policies normally do not allow loans to new businesses or  businesses in the applicant’s industry.
Any other factors relating to the credit that, in the lender’s opinion, cannot  be overcome without the guarantee.
The lender may also use one of the following lender-related reasons: The  requested loan amount exceeds the lender’s legal lending limit or policy  limit on the amount it can lend to one customer, or the lender’s liquidity  depends upon selling the guaranteed portion of the loan on the secondary  market.
section_title: Lenders Assess Availability of Credit Elsewhere against Their Own Underwriting Standards
paragraphs: On the basis of interviews with a sample of lenders and reviews of a  sample of 7(a) loan files, we found that lenders evaluate a borrower’s  ability to obtain credit elsewhere on reasonable terms against their own  conventional lending policies. This finding was generally consistent with  those of a recent Urban Institute report. Lenders we visited most often  cited the borrower’s need for a longer maturity, lack of collateral, and the  age or type of business as reasons for requiring an SBA guarantee.
subsections: section_title: Different Underwriting Policies Result in Different Lending Practices
paragraphs: In practice, lenders evaluate a borrower’s ability to obtain credit  elsewhere against their own conventional lending policies. That is, if a  borrower does not meet the requirements of the lender’s conventional  loan policy, the lender will require an SBA guarantee (or in some cases,  deny the loan request). The criteria or thresholds established in the  lender’s underwriting policies are representative of the level of risk the  lender is willing to assume on a loan. Many factors influence lenders’ risk  tolerance levels, including the size of the institution, its location, and its  financial position. As a result, lenders may focus on different types of  lending or see certain types of lending as being more central to their  operations than others.
Our findings from interviews with a small, nongeneralizable sample of 18  lenders suggest that differences in lending practices could affect how the  credit elsewhere requirement was applied. Some of the lenders said that  they relied on automated underwriting systems that primarily considered  quantitative factors such as credit scores and financial ratios to determine  whether a borrower qualified for a conventional loan or required a  guarantee. But some other lenders said that they also considered  qualitative factors such as the borrower’s relationship with the bank—for  example, the amount on deposit or a prior lending history—when  determining whether to extend conventional or guaranteed credit.
An Urban Institute report on lenders’ implementation of the credit  elsewhere requirement reached similar conclusions. On the basis of  interviews with 23 banks that originated both SBA and conventional loans,  the Urban Institute concluded that lenders that employed small business  credit-scoring models often had relatively straightforward rules regarding  the types of borrowers that were eligible for conventional and guaranteed  loans. However, it also noted that lenders (in particular smaller lenders)  that continued to use relationship underwriting were less likely to have  objective thresholds borrowers had to meet in order to qualify for  conventional financing.
section_title: Lenders Cite Similar Reasons to Substantiate Credit Elsewhere Decisions
paragraphs: Using information collected from 238 recently approved 7(a) loan files  from 18 lenders, we found that the most common reasons lenders cited to  substantiate that borrowers could not obtain credit elsewhere were (1)  that the business needed a longer maturity than the lender’s policy  permitted, (2) that the borrower’s collateral did not meet the lender’s  policies, and (3) that the lender’s policies did not normally allow loans to  new businesses or businesses in the applicant’s industry (see table 1).
The results of our file reviews generally were consistent with the findings  of the Urban Institute’s report on lenders’ implementation of the credit  elsewhere requirement. The Urban Institute concluded that the most  common reasons lenders cited to substantiate that borrowers could not  obtain credit elsewhere were that the business needed a longer maturity  than the lender’s policy permitted and that the borrower’s collateral did  not meet the lender’s underwriting requirements.
As table 1 shows, the most common reason that lenders we visited cited to  substantiate that a borrower could not obtain credit elsewhere was that  the borrower needed a longer term (maturity) than the lender could  provide with a conventional loan. In general, SBA-guaranteed loans  provide more generous terms to borrowers than conventional loans. In  2007, we found that almost 80 percent of 7(a) loans had maturities of more  than 5 years, compared with 5 years or less for an estimated 83 percent of  conventional loans (see fig. 1).
In general, longer terms mean lower payments, which allow borrowers to  service debt with a lower net operating income (see table 2).
Many lenders with whom we spoke said that they generally required a  business to have an actual or projected debt service coverage ratio  (DSCR) of at least 1.10 to 1.25 to obtain a conventional or guaranteed loan.  DSCR is the ratio of net operating income (or cash flow) to debt payments,  with a lower ratio indicating less ability to meet debt service payments.  Our analysis of DSCRs showed that both the average and the mean ratios  for all borrowers in our sample were higher than the 1.10 to 1.25 lender  requirement (see fig. 2). We also found that lenders sometimes deviated  quite substantially from their required minimums. In some instances,  lenders provided loans to businesses with low or negative ratios,  suggesting that those borrowers compensated for a lack of cash flow in  the short term with collateral, for example. In other instances, lenders  provided loans to businesses with ratios well above the minimum  requirement, suggesting that factors other than cash flow were behind the  reasons for requiring an SBA guarantee.
Of the loans that we reviewed, 46 percent were cited as having insufficient  collateral (because of its low value or uniqueness) for a conventional loan.  SOP 50-10 stipulates that a 7(a) loan request cannot be denied on the basis  of inadequate collateral, noting that one of the primary reasons lenders  used the 7(a) program was to provide credit to small businesses that could  repay a loan but lacked the collateral needed to cover it in case of  default. One lender that we interviewed required all conventional loans to  be fully securitized. If a borrower was unable to provide 100 percent  collateral against the value of the loan, the lender would require an SBA  guarantee. Other lenders had more lenient policies relating to collateral,  allowing borrowers to obtain conventional financing with more limited  collateral.
Finally, as shown in table 3, our review of lender files showed that all but 2  of the 18 lenders made at least one 7(a) loan to a new business, but that  some made significantly more of these loans than others. Many lenders we  interviewed said that their conventional lending policies prohibited them  from making conventional loans to new businesses.
section_title: Limited Guidance Impedes Effective Oversight of Lenders’ Compliance with the Credit Elsewhere Requirement
paragraphs: A lack of guidance to lenders on how to document compliance with the  credit elsewhere requirement impedes SBA’s oversight of compliance with  the requirement. SBA requires lenders to explain in a borrower’s loan file  why the borrower could not obtain credit elsewhere on reasonable terms,  but its guidance does not provide specific information on what lenders  should include in their explanations. Our review of on-site review reports  completed during a recent six-quarter period found that SBA determined  that 31 of 97 lenders reviewed had not consistently documented that  borrowers met either the credit elsewhere requirement or personal  resources test. Although all but 1 of the 18 lenders with delegated  authority that we interviewed documented their credit elsewhere  decisions in some way, the explanations in the files we reviewed were  generally not specific enough to reasonably support the lender’s  conclusion that borrowers could not actually obtain credit elsewhere.
subsections: section_title: Guidance on Documenting Credit Elsewhere Decisions Is Limited
paragraphs: Internal control standards for federal agencies and programs state that  good guidance (information and communication) is a key component of a  strong internal control framework. Internal controls are an integral  component of an organization’s management that provides reasonable  assurance that the organization is meeting its objective of ensuring  compliance with applicable laws and regulations. For an entity to run and  control its operations, it must have relevant, reliable, and timely  communications relating to external as well as internal events. Therefore,  management should ensure that there are adequate means of  communicating with, and obtaining information from, external  stakeholders.
Although SBA’s guidance requires lenders to document the reasons that  borrowers cannot obtain credit elsewhere, it does not specify what exactly  lenders should include in their explanations. The only guidance in SOP 50- 10 on documenting compliance with the requirement is a sentence stating  that the lender is required to substantiate the factors that prevent the  borrower from obtaining credit elsewhere and retain the explanation in  the small business applicant’s file. SBA recently revised SOP 50-10 but did  not change the guidance on documenting compliance with the credit  elsewhere requirement. According to SBA, SOP 50-10 provides thorough  guidance on what is required of lenders for making the credit elsewhere  determination and documenting it in the file. To supplement the revised  guidance, SBA has issued on its Web site some frequently asked questions  about the new SOP. To date, no questions on the credit elsewhere  requirement have been posted.
section_title: SBA Reviews Have Identified Deficiencies in Documenting Compliance with the Credit Elsewhere Requirement
paragraphs: SBA’s Office of Credit Risk Management is responsible for monitoring and  evaluating SBA lenders and implementing corrective actions as necessary.  Its primary means of ensuring compliance with the credit elsewhere  requirement is on-site reviews of large 7(a) lenders—those lenders with  outstanding balances on the SBA-guaranteed portions of their loan  portfolio amounting to $10 million or more. SBA also conducts on-site  reviews of large certified development companies (CDC) that make 504  loans. According to SBA officials, the 7(a) and 504 lenders that SBA plans  to review on site over a 2-year period will account for about 85 percent of  all guaranteed dollars. SBA relies on a contractor to perform these on-site  lender reviews. According to SOP 51 00—SBA’s guidance on on-site lender  reviews—the purpose of the on-site review is threefold: (1) to enhance  SBA’s ability to gauge the overall quality of the lender’s 7(a) or 504  portfolio; (2) to identify weaknesses in an SBA lender’s SBA operations  before serious problems develop that expose SBA to losses that exceed  those inherent in a reasonable and prudent SBA loan portfolio; and (3) to  ensure that prompt and effective corrective actions are taken, as  appropriate. In prioritizing lenders for review, SBA primarily considers  the following factors: portfolio size, risk rating, date of last review, and  findings from previous reviews. In addition to assessing performance, SBA  also prepares a written report and follows up with the SBA lender to  address weaknesses or deficiencies identified during the review.
As part of these oversight reviews, the SOP requires SBA to determine  whether lender policies and practices adhere to SBA’s credit elsewhere  requirement. This includes checking to see whether lenders have applied a  personal resources test to confirm that the desired funds were not available  from any principal of the business. With respect to the credit elsewhere  review, SBA’s contractor explained that it checks to see that the lender  documented its credit elsewhere determination and cited one of the six  acceptable factors listed in SOP 50-10. However, it does not routinely assess  the lender’s support for its credit elsewhere determination. Contract staff  performing an on-site review use a checklist that requires the examiner to  answer yes or no that “written evidence that credit is not otherwise available  on terms not considered unreasonable without guarantee provided by SBA”  was in the file and that the “personal resources test was applied and enforced  according to SBA policy.” Contractor officials stated that when the  documentation standard is not met, the examiner will sometimes look at the  factual support in the file to independently determine whether the credit  elsewhere requirement or personal resources test was actually met.
Our review of a sample of SBA’s on-site review reports showed that SBA  determined that nearly a third of lenders had not properly documented that  borrowers met either the credit elsewhere requirement or the personal  resources test. We analyzed reports from all the on-site lender reviews SBA  conducted during a six-quarter period from October 2006 to March 2008 and  found that 31 of the 97 lenders reviewed did not consistently document that  borrowers met the credit elsewhere requirement or personal resources test.  We had to perform this analysis because, until very recently, SBA did not have  a system in which it recorded the results of on-site reviews. One on-site  review report we analyzed stated that “the credit elsewhere assessment was  missing in 24 percent of the cases reviewed.” Another report stated that “the  lender failed to properly document the personal resources test in 20 of the 22  cases reviewed.” As shown in figure 3, the percentage of files at each lender  that were cited for not including credit elsewhere documentation ranged from  a low of 3 percent to 89 percent. Similarly, the percentage of lender files that  did not include documentation of the personal resources test ranged from a  low of 3 percent to 100 percent.
We also found that in each of the 31 cases where there was a finding, SBA  required the lender to take corrective action. When conveying the results  of an on-site review to a lender, SBA instructs the lender to take corrective  actions in response to any findings. The lender then is required to respond  to SBA with information on the specific actions it plans to take. In  subsequent correspondence with the lender, SBA indicates whether the  action taken in response to the finding was satisfactory. As shown in  figure 4, corrective actions taken by the 31 lenders with credit elsewhere  or personal resources test findings included changes in their procedures to  address identified deficiencies, such as updating forms to reflect the credit  elsewhere requirement and personal resources test. In all 31 cases, SBA  determined that the actions taken by lenders were satisfactory.
In contrast to SBA’s on-site review results, our file reviews revealed that  all but one of the lenders included some credit elsewhere documentation  in their loan files. We found that besides certifying on the application that  credit was not available on reasonable terms from other sources, lenders  generally summarized their credit elsewhere determinations in the lender’s  assessment of the borrower, commonly referred to as a “credit memo.”  SBA’s on-site reviews appear to have had some impact on lender  documentation. The majority of lenders we visited told us that SBA’s  contractor had conducted an on-site review prior to our visit. In addition,  representatives of two lenders told us that their on-site reviews had  resulted in corrective actions related to the credit elsewhere requirement.  An official from one lender stated that it had developed formalized polices  and procedures for its 7(a) lending program and revised its forms and the  format of the bank’s credit memo to help ensure that their credit  elsewhere determinations were documented. Officials representing the  other lender stated that they require a checklist for their SBAExpress  loans to remind staff to document credit elsewhere decisions.
section_title: Lenders’ Documentation of Credit Elsewhere Decisions Generally Was Not Specific Enough to Reasonably Support the Determination That Borrowers Could Not Obtain Credit Elsewhere
paragraphs: Although all but one of the lenders we visited documented their credit  elsewhere decisions in some way, our review of documentation provided  to support credit elsewhere decisions in 238 loan files showed that most  lenders did not provide detailed information on why borrowers could not  obtain credit elsewhere. For instance, a number of lenders we met with  used a checklist to document their credit elsewhere decisions. These  checklists allow lenders to select one or more of the six acceptable factors  outlined in SBA’s SOP 50-10 that “demonstrate an identifiable weakness in  the credit of a borrower or exceed the policy limits of the lender.”  However, they do not prompt lenders to provide more specific  information, such as how a longer maturity would improve a business’s  ability to repay a loan or the details on insufficient collateral.
Some lenders also documented their credit elsewhere decisions in credit  memos, but the information provided was generally not very specific.  Some examples of credit elsewhere statements in lender files included the  following:  “ examined the availability of credit and determined that the  desired credit is unavailable to the Applicant on reasonable terms and  conditions without SBA assistance taking into consideration prevailing  rates and terms in the community in and near where the applicant will be  conducting business. Specifically, the Applicant would not be able to  obtain the proposed financing for this specific purpose without federal  assistance.”  “The terms and conditions offered are not available in the marketplace  without the assistance of the SBA guarantee.”  “Repayment capability requires maturity that exceeds  policy;  value of available collateral is unacceptable; credit unavailable through  conventional loan without a lower loan-to-value ratio.”
As evidenced by the above examples, our review of loan files showed that  most lenders generally did not provide specific information about the  borrower in the statements they included in their explanations, nor did  they elaborate upon the items they indicated on the checklist. The lack of  details pertaining to the individual borrower or the lender’s financial  condition raised questions about the usefulness of the credit elsewhere  documentation provided by lenders. Given the broad authority granted to  lenders, more information specific to the borrower’s or the lender’s  financial condition would help support the lender’s assessment that the  borrower could not obtain credit elsewhere. For example, a statement  containing both the borrower’s available collateral and the amount of  collateral the lender requires for a conventional loan would support the  conclusion that the “value of available collateral is unacceptable.”
However, one lender we visited provided more detailed information about  borrowers’ credit/financial positions and the reasons that 7(a) loans were  more suitable than conventional loans, which provided greater assurance  that the borrower could not obtain credit elsewhere. In addition to  substantiating that the borrower could not obtain credit elsewhere, the  lender provided notes documenting why the borrower was denied a  conventional loan. For example:    Credit elsewhere documentation: “Business is new and does not have  sufficient operating history.” Conventional loan denial: “Length of time in  business and/or current management; inadequate cash flow; delinquent  past or present credit obligations with others; revolving balances to  revolving credit limits is high.”
Credit elsewhere documentation: “Business and personal scores are below  the conventional requirement.” Conventional loan denial: “Foreclosure,  repossession, collection judgment, terms and conditions requested are not  offered on this product. Inadequate cash flow.”
In addition, two other lenders provided more detailed information in some  instances. For example:  “Credit is not available elsewhere due to the fact that the applicant  business is not fully secured by the liquidation value of the collateral being  pledged. In addition, there is only 1 year old repayment ability from past  operations and the applicant requires a maturity greater than the 12 years  that  will go out on commercial loans.” “ would not be willing to provide conventional financing on  this project at rates and terms acceptable to provide sufficient cash flow  for repayment. The fact that the applicants will be injecting 10 percent into  the project and have requested a 20 year term does not qualify for  conventional financing under our present loan policy. We would not be  able to provide funds without the use of the SBA guaranteed loan  program.”
The results of our file review show that most lenders tend to use generic  language to meet credit elsewhere compliance requirements, making it  difficult to determine with certainty whether borrowers could not obtain  credit elsewhere. When conducting oversight, SBA needs to ensure that  lenders are making loans only to borrowers that meet the eligibility  requirements of the program. In the absence of detailed guidance on what  exactly SBA wants lenders to document or a more prescriptive credit  elsewhere requirement, lenders will likely continue to offer limited credit  elsewhere statements in their files, making meaningful oversight of  compliance with the requirement difficult. For more information on how  SBA could create a more prescriptive requirement and the implications of  doing so, see appendix III.
section_title: Conclusions
paragraphs: The 7(a) program is intended to serve creditworthy small business  borrowers who cannot obtain credit through a conventional lender at  reasonable terms and do not have the personal resources to provide it  themselves. In most cases, SBA relies on the lender to determine if a  borrower is eligible for a 7(a) loan, including determining whether the  borrower could obtain credit elsewhere. Relying on lenders with delegated  authority underscores the importance of SBA guidance and oversight.  However, SBA’s lack of guidance to lenders on how to document  compliance with the credit elsewhere requirement impedes the agency’s  ability to oversee compliance with the credit elsewhere requirement.
SBA’s guidance to lenders on documenting compliance with the credit  elsewhere requirement is limited. SOP 50-10 requires lenders to retain  explanations of their credit elsewhere determinations in borrowers’ loan  files but does not specify the amount of detail lenders should include in  their explanations. Even with the lack of detail required, the results of  SBA’s on-site reviews of 7(a) lenders—the agency’s primary means of  ensuring compliance with the credit elsewhere requirement—indicated  that documenting credit elsewhere determinations was a problem for  some lenders. Our review of a recent six-quarter period found that SBA  had determined that nearly a third of the lenders reviewed had not  consistently documented that borrowers met the credit elsewhere  requirement or personal resources test. Further, the results of file reviews  we conducted at 18 lenders raise questions about the usefulness of credit  elsewhere documentation provided by lenders in assessing compliance  with the credit elsewhere requirement. We found that lenders tended to  provide general statements about a borrower’s ability to obtain credit  elsewhere, generally citing just one of the six acceptable factors listed in  SOP 50-10 without customizing the statement to fit the borrower or lender  in question. This practice made it difficult to reasonably conclude that  borrowers met the credit elsewhere requirement. The statute, regulations,  and guidance allow lenders to use their own conventional lending policies  to make case-by-case decisions about which borrowers need an SBA  guarantee. Given the broad authority granted to lenders, requiring  documentation of the analysis supporting their credit elsewhere decisions  could help SBA ensure that the eligibility requirement is being met. By  collecting and analyzing this additional information on how lenders are  applying the credit elsewhere standard, SBA could better ensure that  lenders are complying with the standard. Further, identifying promising  practices used by lenders to document their credit elsewhere  determinations could help SBA develop more specific guidance for  lenders. Absent detailed guidance on what exactly SBA wants lenders to  document in their credit elsewhere determinations, lenders will likely  continue to offer limited information in their files, making meaningful  oversight of compliance with the credit elsewhere requirement difficult.
section_title: Recommendation for Executive Action
paragraphs: To improve SBA’s oversight of lenders’ compliance with the credit  elsewhere requirement, we recommend that the SBA Administrator issue  more detailed guidance to lenders on how to document their compliance  with the credit elsewhere requirement. As part of developing this  guidance, SBA could consider (1) requiring lenders to include the analysis  that supports their credit elsewhere determinations and (2) identifying  promising practices currently being used by lenders. After revising its  guidance, SBA also could consider collecting and analyzing any additional  information lenders are required to provide on how they apply the credit  elsewhere standard.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested SBA’s comments on a draft of this report, and the Associate  Administrator of the Office of Capital Access provided written comments  that are presented in appendix IV. SBA stated that it works to establish  clear guidelines and standards that ensure documented lender compliance  without creating overly burdensome paperwork. It also stated that it  would work with its incoming administrative leadership to use our  findings to create more specific guidance for lenders on documenting  compliance with credit elsewhere standards in a way that achieves this  balance.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies of this report to the Chair  and Ranking Member, Senate Committee on Small Business and  Entrepreneurship; Chairwoman and Ranking Member, House Committee  on Small Business; other interested congressional committees; and the  Acting Administrator of the Small Business Administration. The report  also will be available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-8678 or shearw@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix V.
section_title: Appendix I: 7(a) Lending during the Credit Crisis
paragraphs: Historically, the Small Business Administration’s (SBA) 7(a) program has  been thought of as a countercyclical program or stimulus, meaning that  when conventional credit is tightened, lenders make broader use of the  guarantee program to serve the needs of small businesses. However,  during this most recent economic downturn, the number and value of  approved loans has decreased significantly (see fig. 5).
SBA and others have speculated as to the reasons for this decline.
In October 2008, SBA issued a press release citing “a ‘perfect storm’ of  tightened credit by commercial lenders, declining creditworthiness, and  reduced demand for loans from small business borrowers uncertain about  the future” as the primary reasons for the substantial decrease in 7(a)  lending.
Some lenders have said that the decline in premiums for selling  guaranteed portions of loans on the secondary market has reduced  incentives for those lenders who depend on premium income to make 7(a)  loans. By some estimates, premium rates have declined as much as 60  percent, resulting in significant reductions in income for SBA lenders.
Others cited SBA’s new oversight fees as a disincentive to begin or  continue 7(a) lending. According to SBA, lenders with 7(a) portfolios of at  least $10 million likely will pay oversight fees of between $22,000 and  $27,000.
Finally, some lenders have said that the increased frequency with which  SBA has denied or reduced guarantees on defaulted loans for failure to  follow the rules for documenting loans has created uncertainty among  lenders over whether SBA will honor guarantees, creating disincentives  for lenders to participate in the program.
Although the degree to which these reasons may account for the steep  decline in 7(a) lending is unclear, SBA and Members of Congress have  implemented or proposed measures to stimulate lender and borrower  participation in the program. For example:    SBA issued an interim rule allowing new SBA loans to be made with an  alternative base interest rate, the 1-month London Interbank Offered Rate  (LIBOR), in addition to the prime rate, which was previously allowed.  According to SBA, the prime and LIBOR rates have fluctuated away from  their historical relationship, typically 300 basis points, squeezing SBA  lenders out of the lending market because their costs are based on the  LIBOR rate.
SBA has allowed a new structure for assembling SBA loans into pools for  sale in the secondary market. According to SBA, the enhanced flexibility in  loan pool structures can help affect profitability and liquidity in the  secondary market for SBA-guaranteed loans. Because the average interest  rate is used, these pools are easier for pool assemblers to create, thus  providing incentives for more investors to bid on the loans.
On November 24, 2008, the U.S. Department of the Treasury announced  that it would allocate $20 billion to back the creation of a $200 billion  Term Asset-Backed Securities Loan Facility (TALF) at the Federal Reserve  Bank of New York. TALF will make loans to investors who purchase asset- backed securities made up of small business loans guaranteed by SBA,  auto loans, student loans, or credit card loans. According to SBA, this will  make it easier for lenders to sell the loans they make and use the proceeds  of those sales to make new loans.
Introduced on February 7, 2008, the Small Business Lending Stimulus Act  of 2008 (S. 2612) proposed to reduce 7(a) loan fees and authorize  appropriations to cover such fee reductions. Specifically, the bill proposed  to reduce fees on loans of less than $150,000 from 2 percent to 1 percent,  on loans between $150,000 and $700,000 from 3 percent to 2.5 percent, and  on loans of over $700,000 from 3.5 percent to 3 percent.
Introduced on November 19, 2008, the 10 Steps for a Main Street  Economic Recovery Act (S. 3705) proposed several measures to protect  and expand small business lending, including increasing the amount of  financing available to businesses under the 7(a) program from $2 million  to $3 million, temporarily reducing fees to defray the cost of borrowing for  small businesses, and providing tax breaks to small businesses.
section_title: Appendix II: Objectives, Scope, and Methodology
paragraphs: In this report, we (1) describe SBA’s criteria for determining that  borrowers cannot obtain credit elsewhere and practices lenders employ to  determine that borrowers cannot obtain credit elsewhere and (2) examine  SBA’s efforts to ensure that lenders are complying with the credit  elsewhere provision.
To determine SBA’s criteria for determining that borrowers cannot obtain  credit elsewhere, we reviewed applicable statutes, regulations, and  program guidance. For background on the 7(a) program and the credit  elsewhere provision, we reviewed the legislative history of the 7(a)  program, our previous reports, and studies of the program conducted by  the SBA Inspector General and external organizations. We also  interviewed officials from SBA’s Office of Financial Assistance on  guidance provided to 7(a) lenders.
To determine the practices that lenders employ to meet the credit  elsewhere requirement, we visited 7(a) lenders located in and around the  following cities: Atlanta, Georgia; Chicago, Illinois; Houston, Texas; Los  Angeles, California; New York City, New York; San Francisco, California;  and Washington, D.C. During these site visits, we interviewed officials at  18 lenders and reviewed 238 of their approved 7(a) loan applications. We  selected these lenders to obtain a variety in the types of 7(a) loans they  made (preferred lender program  and SBAExpress loans) and the  size of their SBA loan portfolios. We also considered geographic diversity.  In addition, we interviewed representatives of the National Association of  Government Guaranteed Lenders, the trade association for 7(a) lenders.
Using data obtained from SBA, we ranked 7(a) lenders in each of the  selected cities from largest to smallest based on the number of active or  outstanding 7(a) loans for each lender. With the exception of Chicago and  Washington, D.C., we contacted lenders in each city in descending order  until we achieved our quota (at least three in each city). (See table 4.) For  purposes of this report, we considered small lenders to be those with 50 or  fewer active or outstanding 7(a) loans. We made three attempts to contact  a lender before moving on to the next lender on the list.
The applications we reviewed generally covered loans that were approved  within calendar years 2007 and 2008. The number of files we reviewed at  each lender was based on the size of the lender’s portfolio and GAO staff  resources. On the basis of a pilot test at one lender, we determined that we  could review approximately 20 files during one site visit. As a result, we  reviewed between 5 and 25 of each lender’s most recently approved loans,  depending on the size of the lender. To strengthen the accuracy of the  collection of information from lender files, we validated our data entry for  20 percent of all files reviewed at each lender. The sample of lenders we  visited was not designed to be generalizable to the population of 7(a)  lenders, nor was the sample of loans at each lender designed to be  generalizable to the population of 7(a) borrowers at each lender.
To assess SBA’s efforts to ensure lender compliance with the credit  elsewhere requirement, we reviewed excerpts from all 97 on-site lender  review reports completed from October 1, 2006, through March 31, 2008.  These excerpts documented SBA’s assessment of the lenders’ compliance  with the credit elsewhere requirement and personal resources test. We  also reviewed correspondence between SBA and the 31 lenders that had  credit elsewhere or personal resources test findings. This correspondence  detailed the corrective actions that the lenders had implemented or agreed  to implement to address the identified deficiencies. We interviewed staff  from SBA’s Office of Credit Risk Management on their oversight of 7(a)  lenders and the SBA contractor that performs the on-site reviews on steps  taken during on-site reviews to assess compliance with the credit  elsewhere requirement and personal resources test.
We conducted our work in Atlanta, Georgia; Chicago, Illinois; Houston,  Texas; Los Angeles, California; New York City, New York; San Francisco,  California; and Washington, D.C., between February 2008 and February  2009 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 objectives.
section_title: Appendix III: Implications of Imposing a More Prescriptive Credit Elsewhere Requirement
paragraphs: SBA could revise the implementing regulations and guidance for the 7(a)  program to create a more prescriptive credit elsewhere requirement. For  example, SBA could establish some general guidelines describing quantitative  thresholds or ranges for cash flow and credit score that lenders could  consider when making 7(a) loans. The agency could require lenders who  made loans to borrowers who fell outside of the recommended ranges to  document the reasons for their decisions. Further, additional guidelines could  help lenders determine when it was acceptable to cite reasons associated  with the lending institution itself to substantiate that a borrower could not  obtain credit elsewhere. In such a scenario, some of these reasons might  apply only to certain institutions. For example, only nondepository  institutions, such as small business lending companies (SBLC), might be  allowed to cite as a reason for extending 7(a) credit the need to sell the  guaranteed portion of the loan on the secondary market.
A more prescriptive credit elsewhere requirement would address some of  the challenges with the requirement as it is currently written. For example,  as previously discussed, a broad requirement allows lenders to make case- by-base decisions about the types of borrowers that cannot obtain credit  elsewhere. Because different lenders have different lending policies, the  types of borrowers they serve under the program also differ. The absence  of well-defined eligibility criteria makes it difficult for SBA to determine  whether borrowers receiving 7(a) loans actually could not obtain  conventional credit. In addition, these variations in lending policies and  the types of borrowers served make it challenging for SBA to collect  relevant information for evaluations of how well the 7(a) program is  serving its intended mission. In a July 2007 report on the 7(a) program, we  highlighted the need for SBA to improve upon its current efforts to collect  and evaluate performance data for the 7(a) program. According to SBA, it  is in the process of developing additional performance measures.
A more prescriptive standard could be beneficial in light of proposals that, if  enacted, would reduce fees for borrowers and temporarily change the  program from a zero subsidy program to a positive subsidy program. Such  proposals have been made for reasons such as expanding credit for small  businesses during the current economic downturn. According to SBA and  lenders interviewed as part of an Urban Institute report, the higher fees  currently associated with the 7(a) program act as a credit-rationing  mechanism. They explained that the higher fees deter borrowers who could  obtain credit elsewhere from participating in the program, as the fees  associated with conventional loans are significantly lower. However, if the  fees associated with the program were lowered or eliminated, the impact of  this rationing mechanism would be reduced. With the reduction of fees, a  more prescriptive credit elsewhere requirement that clearly outlines which  businesses are eligible for the 7(a) program could help to minimize incentives  for lenders to make loans to borrowers that have access to credit elsewhere.
However, the increased burden on lenders resulting from a more prescriptive  credit elsewhere requirement could limit their participation in the program  and, as a result, decrease small businesses’ access to credit. In addition, a  more prescriptive standard could arbitrarily exclude some borrowers from  obtaining guaranteed credit but compel lenders to make loans to borrowers  that they and the market did not deem creditworthy. Finally, restricting  lenders’ ability to cite their own reasons to substantiate that a borrower could  not obtain conventional credit might limit access to credit in some  communities, especially those with few lending institutions to supply credit or  those that rely on SBLCs—nondepository institutions with delegated  authority to make 7(a) loans.
section_title: Appendix IV: Comments from the Small Business Administration
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Paige Smith (Assistant  Director), Benjamin Bolitzer, Tania Calhoun, Marcia Carlsen, Emily  Chalmers, Janet Fong, Marc Molino, Carl Ramirez, Cory Roman, and  Jennifer Schwartz made contributions to this report.