effectiveness of the small business administration in financing minority business

EFFECTIVENESS OF THE SMALL BUSINESS ADMINISTRACTION IN FINANCING MINORITY BUSINESS

Timothy Bates

This study focuses upon two loan programs that are administered by the Small Business Administration (SBA): (1) the 7(a) Regular Business Loan Program and (2) the Economic Opportunity Loan (EOL) Program. The SBA offers a wide variety of assistance services to small businesses, including business loans, management assistance, surety bond guarantees, aid in competing for federal procurement contracts, pollution abatement equipment guarantees, and numerous other services. The bulk of SBA assistance to businesses is concentrated, however, in the business lending area, and over 90 percent of all lending efforts are concentrated in the 7(a) and EOL loan programs.

It is difficult to evaluate exactly what the SBA is accomplishing via its minority lending efforts. Peat, Marwick, Mitchell, and Co., in its con- sultant evaluation of the SBA, stated that "SBA relied exclusively on the number of loans being made to measure the success of its programs."1 Annual number and dollar amount of loan approvals are rather crude success measures of SBA business lending efforts. This study will estimate an alternative figure--the number of successful minority businesses assisted through 7(a) and EOL loan programs to measure SBA's impact upon the minority business community. The growth of SBA lending to minorities over time is summarized briefly. Because SBA is seeking to accomplish very diverse objectives with its major loan programs, results in terms of loan losses and number of businesses assisted vary dramat- ically in the different loan programs. This study concludes with an ex- plicit list of policy recommendations that seek to increase our knowledge of the impact of SBA loan programs on the nation's minority business community.

322 The Review of Black Political Economy

BACKGROUND

The 7(a) Loan Program

Under this program, businesses may receive assistance in three possible forms: (I) direct loan---SBA makes the loan directly to the business applicant; (2) immediate participation loan--SBA and a private lending institution each advance a portion of the loan; (3) guaranteed loan--a private financial institution makes the loan, and SBA guarantees the loan against default risk.

The Economic Opportunity Loan Program

The EOL program was initially authorized in 1965 under Title IV of the Economic Opportunity Act. In its present form, it empowers SBA to make direct, immediate participation or guaranteed loans to individuals who are socially or economically disadvantaged. EOL loan recipients must demonstrate that they cannot obtain business financing from other sources on reasonable terms. A majority of the EOL loan recipients have consistently been lower income minority entrepreneurs, but nearly one- third of the EOL borrowers have been nonminorities in the fiscal years since 1976. EOL loans have most frequently been SBA direct loans over the past decade, and guaranteed loans have accounted for a fluctuating percentage (25-45 percent) of all EOL approvals.

Growth of SBA Lending Activity

Since the inception of SBA lending in 1954, its loan approvals have been growing by leaps and bounds (Table 1). In the 1969 through 1978 decade, annual loan approvals rose from 14,006 to 30,926 and loan dollars approved increased nearly five-fold to over $3.2 billion. Increased utilization of SBA loan guarantee programs by commercial banks ac- counts for most of this growth in loan approvals. Prior to the late 1960s, SBA lending activities consisted predominantly in immediate participation loans and SBA direct loans.

SBA's commitment to financing minority business enterprise is a related source of loan volume growth over the past decade. Special efforts to finance minority entrepreneurs provided the impetus for creation and expansion of SBA's second largest business lending program, the

EFFECTIVENESS OF THE SBA

TABLE I SBA Bu~ne~ Loan Approvals

Dollars of Loans Fiscal Year Number of Loans Approved (~ millions}

1954-1959 2,782 131] annual

1960-1965 6,774 304 j ! averages

1966 9,776 377

1967 13,449 599

1968 13,620 649

1969 14,006 674

1970 17,425 864

1971 24,286 1,300

1972 32,373 1,900

1973 31,651 2,090

1974 23,158 1,493

1975 21,802 1,516

1976 25,647 2,006

1977 31,150 2,966

1978 30,926 3,215

Note: Figures for 1973 and later years include 7(a) and EOL loans only. Minor inconsistencies are consistently present in various sources that report numbers of loan approvals and dollars of loan approvals. For example, SBA annual reports for 1974 and 1975 show numbers of loans to minority borrowers that are quite inconsistent. Wherever possible, the above data were taken from official sources that were consistent with one or more additional sources of information.

323

Sources: Overview of SBA's Activities, Hearings before the Sub- committee on General Oversight and Minority Enterprise of the Committee on Small Business, House of Representatives, 96th Congress (Washington, D.C.: Government Printing Office, 1979), pp. 43-44. U.S. Small Business Administration, 1976 Annual Report (Washington, D.C.: Government Printing Office, 1977), p. 27 (Vol. I) and pp. 29- 30 (Vol. II). U.S. Small Business Administration, 197A Annual Report (Washington, D.C.: Government Printing Office, 1975), pp. 37, 39, and 106. David Wollard, Small Business Administration Loan Programs (Washington, D.C.: Government Printing Office, 1974), p. 103.

Economic Opportunity Loan Program. These minority lending programs have zigged and zagged in recent years (Table 2), peaking in 1972 (9,000 loans) and stabilizing in a lower range in the late 1970s.


TABLE2 Economic Opportum~Loansand Loans W MinoH~ Entrepreneu~

Tota l EOL EOL Loans to To ta l Lo a ns Y e a r L o - - A p p r o v a ~ K t n o r i t l e s t o Minor i t , l ee

1965-1968 1,907 (mmmd. - - average)

1969 4,240 3,118 4,654

1970 5.542 4,505 6,262

1971 6,792 5,451 7,776

1972 7,178 5,791 9,016

1973 7,662 5,557 8,842

1974 5,288 3,773 5,711

1975 3,615 2,795 5,255

1976 3,652 2,555 5,470

1977 3,845 2,592 6,072

1978 3,300 2,088 5,975

SBA's Present Profile

In the past several years, the SBA has largely concentrated its business lending efforts on bank loan guarantees under its 7(a) program, but it has consistently maintained an annual volume of 3,000-4,000 EOL approvals. Minority lending activities remain below peak levels of the early 1970s, but they account for 5,000-6,000 of SBA's annual loan approvals. EOL lending and minority loans appear to be stabilizing and accounting for substantial portions of overall SBA lending activities.

Table 3 provides a broad overview of SBA minority loan approvals in the late 1970s. Between 1975 and 1978, SBA approved over 23,000 loans to minority businesses under its 7(a) and EOL programs. The 7(a) program accounted for 56.3% of these loans, while the remaining 43.7% were approved under the EOL initiative. Retail and service firms have been the chief recipients of 7(a) and EOL loans to minorities. Businesses in these two industries received over 70% of all 7(a) and EOL loan approvals (Table 3) during the 1975-1978 time period. SBA loans are rather skewed in terms of their industry distribution. Retail and service firms account for 42% of all businesses in the U.S., while Table 3 shows that they accounted for over 70% of the minority loans approved by SBA.

EFFECTIVENESS OF THE SBA 325

TABLE3 ~stribufion ~ SBALoan Approvals~Minodfi~

by Industry Sectors, 1975-1978

SBA 7(a~ Loan A p p r o v a l s t o M i n o r i t i e s

1975

Industry Sector n

~nstructlon 230 9.1 Manufacturing 288 11.3 Wholesale 130 5.1 Retail 1,104 43.8 Service 644 25.5 Other 128 5.1

"1,976 1977 1978 1975-1978

219 7.2 194 5.5 268 6.7 911 7.0 258 8.5 327 9.3 364 9.2 1,235 9.5 193 6 .4 275 7.8 266 6 .7 864 6 .6

1,503 49.7 1,749 49.8 1,917 48.2 6 ,273 48.2 703 23.3 779 22 .2 950 23 .9 3,076 23 .6 145 4.8 187 5.3 208 5.2 668 5.1

Total 2,522 i00.0 3,021 100.0 3,511 i00.0 3,973 I00.0 13,027 I00.0

SBA EOL Loan

1975 1976

Industry Secto[ ~ % n

Construction 156 5.6 123 4.7 Manufacturing 208 7.4 181 6.8 Wholesale 113 4.0 121 4.6 R~tail 1,320 47.1 1,330 50.4 S e r v i c e 703 25.1 639 24.4 Other 300 10.7 245 9.2

Approvals to Minorities

1977 1978 1975-1978

119 4 .6 126 6 .0 524 5.2 177 6 .8 137 6.6 703 6 .9 121 4.6 91 4.4 446 4.4

1,358 52.3 1,023 48.9 5,031 49.7 582 22.4 518 24.7 2,442 24.1 240 9.2 196 9.3 981 9.7

T o t a l 2,800 100.0 2,639 100.0 2,597 100.0 2,091 100.0 10,127 100.0

Source: Small Business Administration, internal data, 1979.

The distribution of EOL loans across industry groupings reveals a stronger emphasis, relative to the 7(a) program, upon lending to retail and service establishments, while loans to manufacturing and wholesaling firms are less frequent under the EOL program. While retail and service finns received over 73% of EOL loan approvals, minority wholesaling and manufacturing firms accounted for I 1.3% of EOL loans; wholesalers and manufacturers received over 16% of all 7(a) loans in this time period. Consistent with its origins in the mid- 1960s, the EOL program continues to focus upon very small retail and service enterprises. The mean EOL loans to all retail and service firms were $26,488 and $24,910, respectively, from 1975 to 1978---much lower than corresponding mean loan sizes of $78,628 and $82,652 for retail and service firms under the 7(a) program. Loan size and industry distribution statistics are quite similar for the groups of minority and nonminority EOL loan recipients. In contrast, minority and nonminority recipients of 7(a) loans are somewhat dissimilar in the sense that mean loans to minority borrowers are somewhat smaller than nonminority averages, and loan industry distributions reveal rather distinct patterns. Nonminority recipients of 7(a) loans are more heavily


concentrated among manufacturing and wholesaling firms, while minority borrowers are disproportionately found in the retailing and service fields.

ESTIMATING THE NUMBER OF SUCCESSFUL MINORITY BUSINESSES ASSISTED BY SBA APPROVED LOANS

The SBA has traditionally relied upon number of loan approvals to measure the success of its lending programs. One immediate problem with this success measure is the fact that many thousands of SBA approved loans have never been disbursed. Of those loans that are disbursed, many recipient businesses fail to establish or maintain viable operations; the result is typically loan default and discontinuation of business activities. These and related problems suggest that annual number and dollar amount of loan approvals are incomplete success measures of SBA minority business lending efforts. This section estimates the number of successful minority businesses assisted as a useful supplementary measure of SBA's impact upon the minority business community.

The steps used to define the gap between total loan approvals and numbers of successful minority businesses assisted are outlined below:

I. Starting point--all minority loan approvals. 2. Deductions:

A. Approved loans that were not disbursed. B. Loans used to refinance previous SBA loans.

3. For businesses assisted (approvals minus deductions), incidence of loan default in major subsets of SBA programs is estimated.

4. Businesses assisted net of failures (loan defaults) is then identified as a tentative proxy for the number of successful businesses assisted by SBA loan programs.

Because SBA intentionally assumes greater default risks under its EOL lending programs, it is essential to disaggregate the loan data appropri- ately if one is using loan default rates as partial success measures of SBA lending efforts.

When estimating the number of successful minority businesses assisted by SBA, it is necessary to identify differences between the number of loans actually paid out and the number of businesses assisted by SBA loans. A substantial number of SBA loan guarantees represent refinancings of previous SBA guaranteed loans. It is necessary to net out


refinancings to isolate: (1) the actual number of businesses assisted and (2) accurate business failure rates. A business that has received several SBA loans is invariably a failure if it defaults upon its most recent loan, even though earlier loans have been repaid. The procedures outlined above for estimating the number of successful businesses assisted are pursued in the following sections.

Loan Approval vs. Loan Disbursal

For purposes of this study, I obtained from SBA a one percent sample of all 7(a) and EOL loans approved in fiscal years 1972-1976 that had been disbursed as of February 1980. Overall, an estimated 122,700 of the 133,635 loan approvals had been disbursed, leaving 10,935 (8.2%) of the loans not disbursed. My estimated rate of nondisbursal was 8.8% for EOL loan approvals and 8.0% among 7(a) loan approvals.

In an earlier study of 1,074 loan approvals to minorities, Bates found that 8.4% of the approved loans had never been disbursed. 2 Since minority borrowers account for a large share of EOL approvals, these find- ings are quite consistent with the EOL and 7(a) loan program nondisbursal rates reported above. Available evidence quite consistently indicates that 8% to 9% of SBA loan approvals are not disbursed. Further- more, nondisbursals are slightly more common among loans to new firms and EOL loans; because minority borrowers are overrepresented among both EOL program participants and new firm borrowers, minorities defi- nitely appear to experience somewhat higher rates of loan nondisbursal than do nonminorities. On the basis if the 1973 Bates study of minority borrowers and the one percent sample of SBA loan approvals described above, it will be assumed in the remainder of this study that 8.4% of loan approvals to minorities are not disbursed.

Number of Loans Disbursed Net of Refunding Loans

According to one source, a sample of SBA business loans extended in fiscal year 1976 revealed that approximately 30% of the loans were granted to refinance previous SBA loans; when loans are refinanced thusly, the earlier loans are recorded as paid? Because fiscal year 1976 overlapped with recessionary conditions, however, resultant business re- trenching due to cyclical sales declines was generating unusually large volumes of loan refinancing in that particular year. A study of loans to minorities by Bates revealed that 7.1% of the loans to a sample of mi-


nority borrowers were refinancings in the 1968-1970 time period. 4 Fur- ther examination of approximately 400 sampled nonminority firms revealed that (l) refinancings are very heavily concentrated among bank guarantee loans and (2) refinancings grew greatly in frequency among SBA loans after 1970. Because nonminorities are disproportionately heavy borrowers among the bank guarantee loan recipients, they are clearly more likely than minorities to receive refinancing loans.

Regarding the 10-year period ending 1978, available data indicate that loans to minorities consisted of at least 10% refinancing loans. This 10% estimate for minorities represents a conservative estimate of loan refinancings based upon fragmentary evidence. Discussions with SBA per- sonnel clearly reveal two relevant facts about the frequency of loan refinancings: (1) SBA direct loans are very rarely granted to refinance previous SBA loans and (2) SBA does not systematically compile information on loan refinancings among bank loans that SBA guarantees against default risk. The SBA national headquarters simply does not know the proportion of its bank loan guarantees that represent loans to refinance previous SBA loans. The SBA, therefore, has no direct way of measuring either the actual number of businesses assisted by SBA guaranteed loans or the net amount of loan funds injected into small business recipients of SBA guaranteed loans. My estimate--that 10% of loans to minorities represent refinancings of previous SBA loans--relies most heavily upon my examination of over 1,000 individual sampled loan files at various SBA regional offices.

Number of Successful Businesses Assisted by SBA Loans

This section examines the loan default experience of SBA minority loan recipients. The incidence of loan default is estimated separately for (1) minority 7(a) loan recipients and (2) minority EOL loan recipients. Table 4 presents data showing loan repayment status of all disbursed SBA minority business loans that were approved in the fiscal year 1969 through 1973 time period. These data on minority loan recipients show loan repayment status as of June 30, 1976, and they exclude refunding loans. Loans in liquidation are loans with serious delinquency problems while charge-offs have been closed out completely as uncollectable loans. Studies by Bates indicated that EOL loan repayment problems were far more prevalent than default and close-out problems among 7(a) loan recipients. ~ The previously mentioned 1% sample of all 7(a) and EOL loans approved in fiscal years 1972-1976 indicates that serious defaults


TABLE 4 Loan Repayment Status on June 30, 1976,

for Disbursed SBA Business Loans

Year of Loma Dlsbursal M/nority Loan Recipients

1969 # %

Loans disbursed 3,865 I00.0 I. Active 987 25.5 2. In liquidation 182 4.7 3. Paid i n full 1,147 29.7 4. Charge-off 1,549 40,1 5. Sum of liquldatlon and charge-off 1,731 44.8

1970

Loans disbursed 5,172 100.0 i. Active 1,746 33.8 2. In liquidation 276 5.3 3. Paid in full 1,219 23.6 4. Charge-off 1,931 37.3 5. Sum of liquidation and charge-off 2,207 42.7

1971

Loans disbursed 6,358 I00.0 I. Active 2,729 42.9 2. In liquidation 446 7.0 3. Paid in full 995 15.6 4. Charge-off 2,188 34.4 5. Sum of liquidation and charge-off 2,634 41.4

1972

Loans disbursed 7,383 I00.0 I. Active 4,430 60.0 2. In liquldation 583 7.9 3. Paid in full 515 7.0 4. Charge-off 1,855 25.1 5. Sum of liquidation and charge-off 2,438 33.0

1973

Loans disbursed 7,348 I00.0 i. Active 4,977 67.7 2. In liquidation 774 10.5 3. Paid in full 108 1.5 4. Charge-off 1,489 20.3 5. Sum of liquidation and charge-off 2,263 30.8

Source: Adopted from P~chard Klein, "Financial Results of the Small Business Administration's Minority Business Loan Portfolio," University of Michigan Business Review (January 1978), p. 21.

among EOL borrowers were 2.02 times more common for minorities relative to 7(a) loan recipients. Table 4 indicates liquidation and charge- off rates (failure rates) of 42.69% for minorities in the 1969-1971 time period. In light of the proportion of EOL and 7(a) loans received by minority borrowers, a 2.02 ratio of EOL to 7(a) failures for minorities suggests (in conjunction with Table 4) the following failure rates by program during 1969-1971:


1. Minority 7(a) failure rate = 24.6 percent. 2. Minority EOL failure rate = 49.7 percent.

Overall failure rates reported in Table 4 declined somewhat in 1972 and 1973, but these results must be interpreted with extreme caution. After a loan is disbursed, it takes a period of time (that varies with loan maturity) to determine whether the loan will ultimately be successful. Because almost all of the loans under consideration have maturities ranging from five to 15 years, the period required to "season" SBA loans, to judge whether the business recipient will ultimately repay the loan in full, is quite lengthy. 6 For the three years 1969 through 1971, the majority of loans are no longer active as of June, 1976, whereas over 60% of the loans approved in 1972 and 1973 are still active. The lower failure rates for these latter years represent inadequate seasoning of many of the loans under consideration.

Table 5 utilizes the failure rates reported above for minority EOL and 7(a) loans. These estimated failure rates are applied to all loans disbursed during fiscal years 1972 through 1978 in order to estimate what the ultimate failure rates will be for these newer minority loans. Generally declining failure rates in the late 1970s (Table 5) reflect the diminishing numbers of EOL loans approved in these years. Overall estimated failure rates declined from a peak of 43.15% to a low of 33.35% in 1978, reflecting the rather substantial drop in EOL loans relative to the peak EOL approval years of the early 1970s. Whereas more frequent 7(a) loans to borrowers tend to minimize estimated failure rates, more frequent EOL loans to minority borrowers result in maximum failure rates. The estimated failure rate for the entire 1969 through 1978 decade was 39.61% for minorities.

Estimates of failure rates, in combination with the estimated rates of nondisbursal and refunding reported earlier, permit one to measure the number of successful minority businesses assisted by SBA. Table 5 reports total loan approvals less nondisbursed loans, refunding loans, and business failures; remaining firms after these three deductions represent those assisted by SBA who are probably still operating their businesses. These are defined as "successful" firms, while firms whose loans are charged off or in liquidation are defined as "unsuccessful" firms. For the 1969 through 1978 decade, estimated successful minority firms, as a proportion of all SBA minority loan approvals, were 49.79%. In contrast, the corresponding percentage of successful firms amongst nonminority loan approvals was 61.34%.


TABLE 5 Numbers of Successful and Unsuccessful Minority Firms

Assisted by SBA 7(a) and EOL Loans

N o n - f a i l i n g Firms Tota l Loan To ta l Disbursa l s Tota l Number as a P e r c e n t a g e of

Year Approvals Net of Refundln~s of F a i l u r e s F a i l u r e Rate To ta l A p p r o v a l s

1969 ~,654 3,838 1,604 41.79% 48.00%

1970 6,262 5,163 2,228 43.15 46.87

1971 7,776 6,412 2,747 42.84 47.13

1972 9,016 7,434 3,087 41.53 48.21

1973 8,842 7,291 2,942 40.35 49.18

1974 5,711 4,709 1,940 41.20 48.48

1975 5,255 4,334 1,645 37.96 51.17

1976 5,470 4,511 1,638 36.31 52.52

1977 6,072 5,007 1,768 35.31 53.34

1978 5h975 4,926 1 , 6 4 3 33.35 54. ~

Total 65,033 53,625 21,242 39.61% 49.79~

These percentages are admittedly estimates, and they are subject to several known sources of bias, including (I) full loan repayment by firms who fail and (2) recovery and subsequent business success by firms whose loans are in liquidation. Absolutely no evidence exists to facilitate measurement of either of these phenomena. The fact that a loan is paid in full does not mean that a successful business has been established. En- trepreneurs that go out of business are still liable for loan repayments, and they may pay off the outstanding balance from business liquidation proceeds, personal financial assets, or income earned from other sources subsequent to business termination. Furthermore, loan failure rates reported by SBA are subject to errors that tend to underestimate the incidence of business failure. Loans may be reported as active, current loans by SBA even though loan repayments are seriously in arrearsJ Further, banks often neglect to report loan delinquencies to SBA despite terms of the loan guarantee agreement that explicitly require banks to notify SBA in writing within 30 days of any incurred default by a guaranteed borrower. A sample of 455 loans on which notices of delinquency were submitted to SBA was investigated by the Comptroller General's Office. 8 Only 168 of the 455 delinquency notices were submitted within the required 30 days. The ranges into which the late notices fell are shown oelow.


Range in Days Number of Loans 31- 59 73 60-89 67 90-119 59

120-179 39 180-299 30

300 and over 10 undeterminable 9

Concealment of loan delinquency amongst SBA active loans is a major reason for using only well-seasoned loans to estimate the business failure rates reported in Table 5. The probability that a delinquent loan will be placed in liquidation is directly related to the duration of delinquency, and delinquency duration is directly related to the length of time that a loan has been outstanding. SBA estimates of loan recipient failure rates are far lowerthan those reported herein partially because SBA estimates typically do not attempt to disaggregate recent loans from well-seasoned loans. While SBA failure rate estimates are plagued by all of the error sources discussed above, these same error sources should have a much smaller impact upon the failure rate estimates reported in Table 5.

Other Evidence on SBA Loan Failure Rates

SBA published estimates of their loan delinquency, liquidation, and loss rates tend to be unenlightening because (1) relatively new loans are not distinguished from seasoned loans, (2) some delinquent loans are classified as current loans, (3) some loans have been repaid from proceeds of subsequently larger SBA loans, and (4) other loans experiencing problems have had their loan payments deferred. Klein's studies on SBA loan liquidations and close-outs represent the most comprehensive data source on loan failure rates, and they have been used extensively herein (Table 4). Klein also reports that bank guarantee loans have shown consistently lower failure rates than SBA direct loans, but this finding is obscured by his inclusion of refinancing loans (which are predominantly bank guarantees) in his data base. Despite this flaw (which produces underestimates of failure rates), his finding that over 15% of all bank guarantee loans made during fiscal years 1968 through 1976 had been repurchased by SBA as of June 30, 1976, is of great interest. ~ Bank guarantee loans are repurchased by SBA only in cases of severe loan delinquency, and most of these repurchases are ultimately charged off as bad loans. During the 1968-1976 time period, Klein found that 120,642 SBA guaranteed loans


had been disbursed, and 18,750 of these loans had been repurchased by June 1976.

Regarding the estimated failure rates for the 1969 through 1978 decade (Table 5), a possible source of bias arises due to the severity of the 1974-1975 recession. Available evidence indicates that recession lessens the profitability of SBA business loan recipients; reduced profitability diminishes loan repayment ability and, hence, the likelihood of default by SBA borrowers increases during recessionary times, l~ As a supplement to (Table 5) the loan failure rate estimates described previously, I obtained data on the actual repayment status of random samples of loans approved during the early to mid 1970s. In April 1980, I collected from SBA repayment records the current loan repayment status for several random samples of loans that had been approved in fiscal years 1972-1976. For minorities, this information was obtained for 1% of all 7(a) and EOL loans disbursed, and 42.6 percent of these firms had failed by spring 1980 (Table 6). For comparison purposes, current repayment status was obtained for 0.5% of all 7(a) and EOL loans disbursed to nonminorities, and 21.3% of these firms had failed by spring 1980. These random samples were drawn from a universe of all 122,700 SBA loans actually disbursed that had been approved during the 1972-1976 time period; 10% of all minority loans and 20% of all nonminority loans were, by assumption, paid off by later SBA refunding loans. Loans repaid by subsequent refunding loans were not included in the Table 6 calculations of successful and unsuccessful firms. Failure rates for minority firms were 26.4% and 53.3%, respectively, for 7(a) and EOL loan recipients, while the corresponding failure rates for nonminority firms receiving 7(a) and EOL loans were 20.2% and 43.8%. These failure rates are accurate estimates of overall SBA failure rates during this time period, except for the case of EOL loans to nonminorities. Due to the very small number of EOL loans to nonminorities observed in the 0.5% sample of nonminority loan dis- bursals, an additional 1.0% sample was randomly selected solely for nonminority EOL recipients. Based upon this expanded data set, the observed failure rate for nonminority firms receiving EOL loans was calculated at 35.6%.

Failure rates reported in Table 6 are in every category higher than the estimated failure rates (Table 5) that were obtained by extrapolating 1969-1971 loan repayment information to the years 1972-1978. The probable explanation for these high failure rates on loans approved in 1972 through 1976 is the severity of the recession that occurred in 1974- 1975. Alternatively, SBA may have been lending to increasingly risky


TABLE 6 Repayment Status for Sampled Firms Who Received SBA 7(a) and

EOL Loons During Fiscal Years 1972 Through 1976

7(a) EOL Total

Success Failure Total Success Failure TotaI Success FaLlu~e Total

A. R e l a t i v e

Nonminority 79.8% 20.2% I00% 56.2% 43.8% 100% 78.7% 21.3% 100%

Minority 73.6% 26.4% 100% 46.7% 53,3% i00% 57.4% 42.6% 100%

B. Absolute

Nonminority 265 67 332 9 7 16 274 74 348

Htnor i~y 81 29 110 78 89 167 159 118 277

finns (cyclical conditions notwithstanding) in the early and mid-1970s. Clearly, overall failure rates of 39.6% to 42.6% for minorities indicate that loan default and business failure are problems that consistently typify a substantial portion of the SBA loan portfolio. Failure rates observed among EOL loan recipients are consistently very high, and they are largely responsible for the disproportionately high incidence of failure that characterizes minority finns relative to nonminority enterprises.

A study by the comptroller general of 845 minority business SBA loan recipients in three cities reported that 27.5% were failures and 25.2% were probable failures. Among recipients of SBA direct (predominantly EOL) loans, rates of failure and probable failure were 36% and 29%, respectively, while bank loan guarantee recipients had estimated failure and probable failure rates of 19% and 23%. 11

High loan default and failure rates among minority borrowers have been instrumental in eroding the credibility of government programs de- signed to finance minority enterprise. A study by Bates and Bradford argued that these default rates are directly related to the underlying phi- losophy of the EOL program that requires minority loan recipients to be bad credit risks) 2 Aside from computing number and dollar amounts of minority loans, the SBA has not established goals for evaluating its minority lending programs. In light of the high failure rates consistently reported by various studies of SBA minority lending efforts, it would appear logical for SBA to rationalize further minority lending efforts in terms of such reasonable goals as (1) the number of successful firms assisted and (2) the economic value to the minority community of types of finns assisted. '3


CONCLUDING COMMENTS

Although SBA claims that it approves over 5,000 loans annually to minority borrowers, the number of firms actually assisted is considerably less due to nondisbursal of approved loans and use of new loans to refinance previous SBA loans. Among firms actually receiving loans, observed failure rates range from a low of 26.4% for minority 7(a) loan recipients to 53.3% for minority EOL loan recipients. These high inci- dences of failure reduce the effectiveness of SBA loan programs, and in conjunction with nondisbursals and refundings they bring the proportion of successful firms assisted down to less than 50% of all SBA minority loan approvals. Because of their higher failure rates, successful minority firms assisted account for less than half of all minority loan approvals, while about 60% of nonminority loan approvals eventually translate into successful businesses who repay their loans.

SBA should publish annual estimates of the number of successful firms that have received assistance through its lending programs. To facilitate these goals, SBA would have to report not only estimated default and close-out rates, but also:

1. The number of loans actually disbursed. 2. The number of refunding loans. 3. The number of fully repaid loans that represent successful business

establishments or expansion.

In light of the high default and failure rates that plague SBA minority lending efforts, including their bank guarantee loans, the agency needs to justify these failure rates or reduce them. In this spirit, some candidates for serious consideration by SBA include:

1. Determining a tolerable default rate for EOL loans and reducing, if necessary, loan approvals in cases where default risks are unac- ceptably high.

2. Charging fees for insuring bank loans that are directly related to loan default risk; alternatively, the proportion of loan proceeds that are guaranteed against loss could be reduced for risky loans or banks with bad loan repayment track records could be denied full 90% default coverage.

3. Lend where chances of successful business assistance are greatest, and


assume grea te r defaul t r isk on ly for such specif ic na t iona l goals as

p r o m o t i n g j o b s in high u n e m p l o y m e n t areas.

NOTES

I. U.S. Comptroller General, Limited Success of Federally Financed Minority Busi- nesses in Three Cities (Washington, D.C.: General Accounting Office, 1973), pp. 69-70.

2. Timothy Bates, Black Capitalism." A Quantitative Analysis (New York: Praeger, 1973), p. 36.

3. Richard Klein, "SBA's Business Loan Programs," Atlantic Economic Review (September/October 1978), p. 34. Klein further states that "SBA surveys disclose that approximately 20 to 30 percent of the new business loans made were for the purpose of refinancing previous SBA loans" (p. 34).

4. Bates, Black Capitalism, p. 36. 5. Timothy Bates, "Government as Financial Intermediary for Minority Entre-

preneurs: An Evaluation," Journal of Business (October 1975), pp. 543-56. 6. When borrower characteristics that measure borrower credit worthiness are con-

trolled for, number of months that a loan has been outstanding still emerges as a powerful determinant of loan repayment status. For example, when time is included in a multiple discriminant analysis equation (along with business cash flow, net worth, liquidity, total assets, owner experience, and other business traits), the results decisively demonstrate that probability of default, ceteris paribus, is directly related to the number of months that the loan has been outstanding. See ibid., pp. 549-55.

7. A review of hundreds of SBA loan files by the author reveals that loans in delinquency for more than one full year are sometimes carried by SBA as active loans.

8. U.S. Comptroller General, The Small Business Administration Needs to Improve its 7(a) Loan Program (Washington, D.C.: General Accounting Office, 1976), p. 40.

9. Richard Klein, "Financial Results of the Small Business Administration's Minority Business Loan Portfolio," University of Michigan Business Review (January 1978), p. 22.

10. This conclusion is related to the phenomenon of high interest rates during early stages of recessions. Since SBA bank guaranteed loans carry floating interest rates, recession induced losses in sales volume are typically accompanied by higher loan repayment obligations for SBA loan recipients. For further evidence on relations between small business failure and macro-economic credit conditions, see Alan Grimshaw and Robert Edmister, "Effects of Changes in Interest Rate Term Structure and Risk Premium on Small Business Loan Failure Rates," presented at the April 1980 Eastern Finance Associ- ation meeting (unpublished manuscript), pp. 13-19.

I 1. U.S. Comptroller General, Limited Success . . . . pp. 26-29. 12. Timothy Bates and William Bradford, Financing Black Economic Development

(New York: Academic Press, 1979), p. 176. 13. See ibid., chapters 9 and 10, for further elaboration on this theme.

effectiveness of the small business administration in financing minority business

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