‘Deficiencies’ Seen in Review of SBA-Guaranteed Loans

Few government agencies have embraced privatization like the Small Business Administration. Bankers, not SBA employees, now make most of the lending decisions that channel billions in government-backed loans to business borrowers each year.

But aggressive outsourcing has hampered the SBA’s ability to keep tabs on the loans it guarantees, according to a recent government audit. In its review of the SBA’s most popular lending program, the federal Office of Inspector General found that in half of the loans it examined, lenders didn’t follow all the procedures set down by the SBA.

Most of those so-called deficiencies are minor paperwork issues. Still, the IG found that 11% of the loans it examined--estimated to represent more than $400 million in SBA-backed loans--contain errors or omissions serious enough to invalidate the loan guarantee or require the SBA to take action to protect taxpayers’ interest. Most of these errors occurred in the up-front credit screening and loan disbursement processes, where the SBA has little or no oversight over its partner lenders, according to the IG.

The auditor’s findings do not mean that the loans in question will go bad. In fact, defaults in so-called 7(a) loans are on the decline. Still, the findings underscore some of the inherent risks the agency takes in guaranteeing loans it has no hand in underwriting.

“The Inspector General’s audit amounts to a wake-up call that I hope the SBA will heed,” said Sen. Christopher S. Bond (R-Mo.), chairman of the Senate Committee on Small Business. “Federal banking regulators have been urging commercial lenders to beef up their efforts to guard against unnecessary losses, and the SBA needs to follow their lead.”

The audit, which was conducted last year, completed last month and obtained by The Times through a Freedom of Information Act request, examined 240 loans from eight randomly selected SBA offices, including the Los Angeles district office in Glendale. IG Auditors looked at 240 loans worth $74 million from the SBA’s 7(a) program, which were approved between March 1, 1996, and June 30, 1997. Under the 7(a) program, banks lend money to small-business borrowers who are unable to obtain general business financing through traditional channels. SBA guarantees as much as 80% of the value of each loan, up to a maximum of $750,000. The SBA will extend about $10 billion in loan guarantees through the 7(a) program this year.

Once a direct lender, the SBA began transforming itself years ago into a guarantor of loans underwritten by private-sector lenders. This allowed the SBA to stretch taxpayer dollars and expand its lending programs, while taking advantage of the expertise of seasoned bankers. The trend in recent years has been to shift even more of the initial credit screening to its lending partners as the SBA has trimmed its staff. According to the IG, more than 75% of SBA’s loan volume now occurs in programs in which the agency has little or no involvement in the upfront credit reviews.

While this is more efficient for lenders and borrowers, the IG says the shift has made it tougher for SBA to determine whether lenders are following agency procedures. That information is key when a loan defaults because if lenders have failed to comply with important SBA rules, the agency can reduce its guarantee or refuse to honor it at all.

However, IG found that this rarely happens. In the last five years, the SBA denied payment for only nine out of 1,918 defaults in the eight districts covered by the audit--a 0.5% denial rate. (The SBA did not keep figures for the loans in which it paid only a portion of the guarantee.)

In contrast, IG auditors found that at least 5% of the loans it examined should never have been approved because the borrowers had a poor credit record, questionable character or some other disqualifying condition. In another 6% of the loans examined, the lenders failed to ensure that the borrowers followed through with some major component of the loan agreement, such as putting more equity into the business or using the loan proceeds correctly.

The IG estimates that this 11% slice of loans with material deficiencies represents $405 million worth of SBA-backed loans in the overall 7(a) portfolio. No one is suggesting that these loans will eventually default. But SBA needs to hold lenders accountable in the event they do, says Deputy Inspector General Peter McClintock.

“SBA shouldn’t be paying out guarantees when some or all of it isn’t justified,” McClintock said.

Jane Butler, the SBA’s associate administrator for financial assistance, says the SBA already has made a number of improvements, including a review and rating of all 500 lenders in the SBA’s so-called Preferred Lender Program. Lenders in that program are authorized to make SBA-backed loans without prior SBA credit approval. PLP lenders accounted for more than half of all 7(a) dollars lent in 1999.

The SBA’s purchase rates and subsidies to cover losses from the 7(a) program have been declining in the last few years, leading Butler to conclude that the SBA “is headed in the right direction” despite the IG’s latest findings.

However, Bond has promised to make the recent audit report an issue as his committee prepares to write a reauthorization bill for the SBA in March.

“The Inspector General has put a finger on a weakness that merits more review,” he said.