Availability of Credit to Small Businesses and the Financial Crisis of 2008-????

1. Availability of Credit to Small Businesses and the Financial Crisis of 2008-???? Rebel A. Cole DePaul University

2. Overview • Small business financing • Small-business credit allocation process • Impact of financial crisis on availability of credit to small firms • Banking • Real Estate: Commercial and Residential • Regulatory Backlash • Appraiser Backlash • Unemployment

3. Small Business Financing in U.S. • Most small businesses rely upon banks for debt financing. • Small businesses typically use real estate as collateral for loans. • Most small businesses also use personal and business credit cards for debt financing.

4. Non-Borrower No Discouraged Borrower (1) Need Credit? Unsuccessful Borrower Yes No Yes (2) Apply for Credit? No Yes Successful Borrower (3) Get Credit? Small-Business Credit Allocation Process:Three Steps Source: “Who needs credit and who gets credit?” Cole (2008)

5. Credit-Allocation Outcomes Source: “Who needs credit and who gets credit?” Cole (2008) Data from Fed’s SSBF

6. Banks • Lending has fallen at 19% annual rate during past three months. • Business lending has fallen at 28% rate. • Why? • Banking system is in serious trouble that continues to worsen.

7. Banks • Failures pass 100 for first year since 1992. • More than 400 “problem” banks.

8. Banks • Asset quality continues to deteriorate. • NPLs rose from 2.95% to 3.76% in Q2 2009, to highest level since 1991. • Based on asset quality, several thousand are constrained in ability to make new loans. • Industry holds $700 billion in HELOCs. • Big Four (JPM, BofA, Citi, WFC): $420 billion • Industry holds $1.6 trillion in Commercial Real Estate loans, of which almost $600 billion are Construction & Development.

9. Real Estate • Most small businesses pledge real estate (personal and/or business) as collateral when applying for credit. • During the crisis, residential real estate values have fallen precipitously. • Currently, commercial real estate values are following suit.

10. Residential Real Estate • Values have dropped from 2007 highs to 2002-2003 levels: • Depending upon locale, this means value has fallen 20% to 50%. • Both delinquency and foreclosure rates continue to hit new all-time highs month after month (source: LPS). • Sep.: combined 12.49% (9.37% Del. / 3.12% Forc.) • Aug.: combined 12.20% (9.06% Del. / 3.04% Forc.) • More than 600,000 NEW delinquencies each month. • Compare with 500,000 TOTAL trial modifications.

11. Option-ARM Tsunami is Coming

12. Commercial Real Estate • Continuing and serious deterioration. • “Cap rates” fell as low as 4% at market peak in 2007, but now have skyrocketed to 8% and higher. • “Cap rate” is essentially a discount rate for valuing real estate income as a perpetuity. • This means that CRE property values have fallen by as much as 50% or more.

13. Credit Cards • Banks are aggressively cutting back on credit lines, especially credit cards. • Credit-card losses are at all-time highs. • Estimate are that credit-card credit lines have been cut by 25% and more during the crisis. Down $400B in 2009 Q2 alone. • Many unused credit lines have been cancelled. • SSBFs: Most small businesses use credit cards to finance their firms. • This is seriously impacting the availability of credit to these firms.

14. Regulatory Backlash • Bank examiners have tightened standards. • Yesterday’s performing loans are today’s non-performing loans. • “performing non-performing” loans have returned, but now because collateral values have fallen, even if cash flow is sufficient to cover debt service. • More NPLs => More required capital=> less lending. • Banks have responded to the whip by tightening underwriting standards. • Higher standards => less lending

15. Appraiser Backlash • Real estate appraisers strongly criticized for role in mortgage meltdown. • MAI = “made as instructed.” • Now much less generous in valuations. • Many inappropriately use distressed sales as comparables, pushing values down. • Huge problem for owners of CRE properties • Typically use short-term financing. • Need to refinance, but cannot because properties appraise at less than original loan amount. • Bring new money to the table or default.

16. Unemployment • Disproportionately falling on small businesses, including the self-employed. Currently 9.8% (10.3% for men) • HH Survey: 785,000 jobs lost in Sep. • Estab. Survey: 293,000 jobs lost in Sep. • Next Friday: Oct. employment situation • Expect unemployment to rise to 10.0%+ • Likely to stay above 10.0% through 2010. • More job losses=>More RE delinquencies.

17. Summary • Small businesses are critical to the U.S. economy. • Bank loans are critical to health of small businesses. • Banking system remains in dire straits, largely because of residential and commercial real estate markets, which continue to deteriorate. • Rising unemployment leads to continuing deterioration in real estate markets.

18. Summary • In what shape is the economy going forward into 2010 and beyond? • V ? • L ? • W ? • U ?