As far back as two years ago, Marilyn Landis, who owns Basic Business Concepts Inc., a Pittsburgh-based financial services outsourcing company, saw something that most small business owners did not — the first signs of a growing credit crunch. Back then the Federal Reserve was still raising interest rates. Since her firm provides financial services primarily to rapidly growing companies, she’s had a ringside seat to the changing credit market. “What I have watched happen gradually over the last couple of years has gotten a whole lot worse on multiple levels very quickly,” she says. “It’s gotten to the point where the pain is finally starting to hit the headlines.”
While Landis’s observations are largely anecdotal, a new Federal Reserve Bank survey of senior loan officers at 56 domestic and 23 foreign institutions reaches many of the same conclusions. Credit is growing tighter, like a noose around the economy’s neck. Much of the change has taken place over the past three months. The survey found that banks have been tightening lending standards and loan terms on a broad range of products, covering every sector of the economy. If the trend continues, it could not only help tip the economy into a recession, but may extend the depth and prolong the duration of the downturn as well.
The survey, in fact, touched off alarm bells this week on Capitol Hill. Senate small business committee Chairman John Kerry, D-Mass., introduced emergency legislation on Thursday to make more federal funds available for small business loans. Meanwhile, the Bush administration has been caught flatfooted. The president’s FY 2009 budget either cuts or simply maintains current funding, which has been held at 2001 levels for the past seven years. In fact, since the federal fiscal year began in October, SBA lending through the agency’s flagship 7(a) loan program is down 14 percent compared with the same period a year ago. Dollar volume is down 6 percent.
In the broader economy, the Federal Reserve survey found that one-third of domestic institutions reported tightening their lending standards on construction and industrial loans to small, middle-market, and large firms over the past three months. Among other things, banks have raised the cost of credit lines and the premiums they charge on riskier loans. The latest series of Federal Reserve rate cuts, which began in September, was supposed to help lower the cost of credit. But two-fifths of domestic banks surveyed simply increased spreads between loan rates and their cost of funds, essentially pocketing the difference, the survey found.
Landis, who worked in banking for 30 years before starting her own small business, says cutting interest rates won’t help ease the crunch. “Fed rate cuts increase the liquidity of banks. More liquidity means more money to put on the street. So there’s lots of money,” she says. But tighter lending standards have restricted the pool of eligible borrowers. “Banks are saying, ‘bring us deals,’ but they are all chasing the same couple of deals,” she explains. “I talk to people in the field, and this is a direct quote: ‘For every 20 deals I bring in, I get one approved. Deals we used to approve without thinking twice about, we are turning down.’”
The real problem, she says, is “a perception of risk” that has caused bankers to raise the bar on all of their lending criteria. The perception is tied directly to the subprime mortgage crisis, which has triggered rising defaults, a glut of housing, and declining prices. “I don’t blame the banker,” says Landis. “If your portfolio is analyzed and considered under risk, you have to put up more reserves, and it really punishes them.”
William Dunkelberg, chief economist for the National Association of Independent Business, agrees. “Anybody who is smart knows what ails the market can’t be cured by Fed rate cuts,” he says. “It’s not that banks don’t have liquidity, they just can’t get a market price on this incredible pool of mortgages. Nobody knows what’s behind them. Until they figure out the risk, nobody will buy them.
“Unpacking all that stuff is going to take time,” he adds. “Most of the mortgages are good mortgages; they just underestimated the percentage of bad.”
Indeed, the surveyed banks said they tightened credit standards because of a “more uncertain economic outlook, a worsening of industry-specific problems, and a reduced tolerance for risk.” Weakening demand for loans was also fairly widespread.
While construction and industrial loans have grown harder and more expensive to get, the crunch is even more acute in commercial real estate. “About 80 percent of domestic banks reported tightening lending standards on commercial real estate loans over the past three months, a notable increase from the October survey,” the report noted.
Dunkelberg says that credit is available for most small businesses if they are dealing with community banks that have escaped the subprime crisis. Landis agrees and says the problem is most acute among rapidly growing businesses, which “are always a step ahead of their cash flow.” Since most new businesses are also service-oriented, they don’t have hard assets like buildings or machinery, a traditional source of collateral. As a result, many small businesses are being pushed into credit cards when they apply for a line of credit. This is what happened to Landis. Even though she never missed a payment, her bank raised her rates “sky high” because of her increased use of credit. “They said I was a credit risk … it really impacted my ability to grow the business,” she says.
Unless the government takes aggressive action to make sure businesses can continue to borrow money at reasonable rates, Landis won’t be the only small business owner feeling the pain of tight and uncertain credit.
Read the full Federal Reserve report online.