The following written testimony was submitted by Chris, Mercantile CEO and Cofounder to the Senate Committtee on Small Business and Entrepreneurship in advance of his hearing on March 29, 2012.
Testimony of Christopher G. Hurn
Chief Executive Officer and Cofounder of Mercantile Capital Corporation
Before the Senate Committee on Small Business and Entrepreneurship
March 29, 2012
The FY 2013 Budget Request for the Small Business Administration
Chairwoman Landrieu, Ranking Member Snowe, and Members of the Small Business and Entrepreneurship Committee, good morning. My name is Chris Hurn and I am the CEO and cofounder of Mercantile Capital. I am honored to be here today to share my experiences and thoughts, along with those of my colleagues, who have co-signed this written testimony.
As the Committee considers the President’s FY 2013 Budget Request for the SBA, I would like to share a few ideas on how the subsidy for the SBA 504 loan program can be reduced and ultimately eliminated. In these tough economic times, when budgets are shrinking, and the American people are demanding that Washington spend less, I believe that efforts to reduce or even eliminate the subsidy for the 504 program is the best way to ensure its long term strength and effectiveness.
I would like the Committee members to know that the solutions I will be putting forth today have the strong support of, and were developed in conjunction with, many of my colleagues from the SBA 504 industry. I implore you to give them very serious considerations, not only to act to reduce the subsidy and solidify the SBA 504 loan program, but also to enhance the 504 program’s ability to more effectively assist small businesses all over the country. I speak for all of my co-signers when I say that we want the SBA 504 loan program to again become zero-subsidy, as quickly as possible, and to regain its purity as one of the finest examples of a public-private partnership programs available to our nation’s small businesses.
I call my suggested solutions, the three E’s: Empowerment, Extension, and Extra Measures.
One of the most effective ways to reduce the subsidy is to incentivize Certified Development Companies (CDCs) to actively pursue recoveries on their SBA 504 loans. Billions in unnecessary losses on the SBA 504 program are helping drive up the subsidy rate on the program. Recent charge off amounts reported by the SBA reveal that during FY 2011, the SBA walked away from $784,015,047 in delinquent 504 loans with $618,097,680 during FY 2010, and $352,015,223 in FY 2009. As of 12/31/11, $241,209,328 more had already occurred.
Clearly we are in unprecedented economic conditions, and during such times, we should rise to the challenge with an extraordinary response. We have the ability to make a substantial impact without requiring any additional resources from the SBA and taxpayers. Let the CDC industry aid small businesses while dramatically improving the recoveries from 504 loans. This, in turn, will reduce the need for a subsidy and enhance the strength and viability of the 504 program.
CDCs are, in effect, SBA’s experts in the field; they are intimately familiar with their borrowers, the local real estate market, real estate professionals, the economic environment and SBA policies. The main reason more CDCs are not currently pursuing recoveries is because there is no financial incentive to do so. In fact, there is a financial disincentive.
We are cognizant that recoveries are labor intensive and follow a variety of paths. Experience shows that having local experts working with banks and borrowers is a critical component of the success of a recovery program. SBA not only lacks the local connection, but they lack the resources to attack this issue at an appropriate level.
As long as SBA does not have the staff to pursue recoveries and CDCs do not have an incentive, very little will change. Furthermore, SBA seems motivated to quickly remove challenging loans from their portfolio. However, this calculation on the part of the SBA severely limits options to the small business owner, putting the business and associated jobs in immediate jeopardy.
SBA utilizes a calculation to determine if it is appropriate to support the CDC pursuing recovery on a defaulted loan. Unfortunately, this calculation is overly stringent and most of today’s defaulted loans do not meet the criteria in order for SBA to protect that asset. Thus, SBA determines it is best for them to “walk away” from the real estate and expect no recovery; in reality this action severely reduces the possibility of obtaining a recovery. An overwhelming majority of the defaulted loans are turned down by SBA, which results in the billions of dollars landing in SBA’s charge off column, unnecessarily. CDCs, however, are in a unique position to help the struggling small businesses and/or obtain substantial recoveries, even when SBA determines there was little to no value to pursue.
Results from CDC recovery efforts, initiated early on in the process, have been very favorable – from saving hundreds of businesses and thousands of jobs to recovering hundreds of millions of dollars that SBA would not have otherwise obtained.
When SBA declines to protect these assets, the CDCs step in and look at a variety of options that may salvage the company. For each potential action, the CDC will analyze the borrower’s current financial capabilities and determine the appropriate assistance, which may include deferments or workouts (graduated payments, loan modifications including interest rate or term adjustments, and lengthening of the maturity date). If all else fails, the CDC can pursue Offer in Compromises (OICs) and short sales for recovery dollars as opposed to SBA wrapping up the loan with no recovery and sending it off to Treasury.
Given SBA support, qualified CDCs can offer the following accommodations:
- Deferments provide borrowers with a period of six to twelve months (longer with SBA approval) for partial or full deferment of the monthly payments. This often gives borrowers the breathing room they need to straighten out their finances, improve liquidity and build capital needed to keep the company operating. Experiences show a majority of these businesses have been able to get back onto a regular payment plan once their deferment time is complete.
- Workouts are provided to those that did not qualify for a deferment or were unable to re-engage in regular payments at the end of the deferment time. This tactic again focuses on keeping the business intact and saving the jobs. The CDC develops a payment plan that works within the borrowers’ financial resources. This option provides SBA a full recovery and eliminates part of the millions of dollars SBA is charging off. Workouts are put into place after SBA has re-purchased the debenture and thus the CDC has many more options for assisting the borrower, such as reducing the interest rate, modifying the terms of the loan or extending the maturity date. With a combination of these options, the CDC and borrower come to a payment agreement and the business is maintained while the loan is paid in full under the new loan terms and conditions.
- Short sales are utilized when a loan does not qualify for a deferment or workout. The ability for the CDC to quickly get a short sale under way and work directly with third party lender ensures the maximum recovery. Should this process be prolonged – the percentage of recovery often goes down. The key is that the CDC is present and active for the crucial decisions, often made in conjunction the third party lender. When the 504 loan representative is not present, many decisions and sales are made without SBA’s influence or participation and the availability of recovery dollars late in the game goes down substantially.
- Offers in Compromise (OICs) are pursued when all other recovery options have been exhausted. Although OICs are labor intensive, the rigorous research, borrower education and negotiations often result in additional recovery. The CDC works with the borrower to determine all possible payments that could be made in lieu of paying off the loan. These payments are submitted to SBA for final approval. Ultimately, these efforts are successful because CDC staff vigilantly follows the loans from first default and is in the best position possible to affect a positive OIC as an end result. Without such hands on influence, many small businesses are misled to believe bankruptcy is the best or only option left to them.
The CDC also provides assistance and, at times, recoveries from bankruptcies. This is a labor intensive process of following court mandates and the prolonged bankruptcy process, but does provide additional recoveries.
Some CDCs are currently performing these processes without any financial support from SBA. Unfortunately, even the simple costs are not covered by SBA. It should not be a surprise, therefore, that the vast majority of CDCs are not doing more to maximize recoveries.
We understand that defaulted loans are charged off and sent to Treasury for collection, which in turn, pays third-party collectors to pursue recoveries as part of the Treasury’s Financial Management Service (FMS) Cross-Servicing Collection program. This will never be a wildly successful program, nor is it efficient, because the effort is being made very late in the process and typically by an organization and individuals that are not savvy about the SBA 504 loan program, or as familiar with the businesses in question. It is not a surprise, therefore, when we hear that Treasury collects approximately 30% from recoveries.
CDCs, however, because they could start the recovery process very early, are much more likely to catch companies at a point that results in a workout of the loan, rather than a default and subsequent charge off. This approach not only keeps millions of dollars from being in the charged off column, it also acts to retain all of the jobs associated with these struggling companies.
This recommended strategy of empowerment via a real incentive will not increase costs at all for taxpayers. CDCs should be reimbursed only from recovery funds that are actually realized; thus, CDCs only get paid if the recovery funds are returned to SBA. Additionally, on workouts, since there are no proceeds from the sale of collateral, I simply suggest putting the loan back onto regular servicing and allow the CDC to collect the typical servicing fee that they do from every other performing 504 loan in their portfolio.
It is important to remember that in the current environment, SBA is choosing to not defend on the vast majority of these charged-off loans, meaning that in many cases, the dollars that are recovered and actually returned to the SBA are literally the same amount above which the SBA was expecting to collect, because by choosing not to defend on a particular loan, the recovery on that loan would have been ZERO.
One CDC, alone, has placed 48 small businesses on workout status, thereby saving roughly 750 jobs and keeping nearly $35 million from being charged off by SBA. Imagine how astounding these numbers could be if they were applied across the nation. At the very least, in light of the lack of funds necessary, we urge the Committee to consider, at a minimum, instituting a pilot program to increase the volume of recoveries across the nation and allow CDCs to participate directly in such a pilot program, or “outsource” their recovery efforts to those CDCs that are willing to participate. Common sense suggests that only in this way will recoveries be dramatically improved over what the Fresno or Herndon offices are currently capable of doing.
Furthermore, the process works best if SBA would support the CDC’s efforts by expeditiously giving the CDC documentation needed to pursue the property or recoveries and signing off on any required data or strategies. Then the CDC can more easily address recoveries effectively. This will free up SBA staff to concentrate on other issues, act to maximize recoveries by quickly utilizing experts in the field, reduce the cost for SBA staff to work on recoveries and ultimately provide a smoother process and result in minimizing program losses This also eliminates SBA staff pressure to wrap up defaulted loans and get these loans off of the SBA books, which only serves to cut off the borrowers’ options and reduce any chance of saving businesses (and jobs) while maximizing recoveries.
It is through timely, dedicated, purposeful actions that CDCs find great success with recoveries. CDCs provide the local presence that is willing to get involved and fight for every job, every business and every dollar of recovery. The businesses need an ally and the SBA needs to encourage these kinds of recovery efforts across the country.
Given the opportunity to cover costs and share in the recovery dollars, this will create a “win-win-win” scenario: SBA will benefit from increased recovery dollars; CDCs will benefit from minimizing the losses, which in turn reduces the subsidy requirement; and, in the end, borrowers continue to benefit from one of the finest small business capital access programs available.
Solution: EMPOWER CDCs to make recoveries in the 504 loan program and develop an incentive model to do so effectively, efficiently and fairly, based on previous practices within other agencies and departments of the federal government, and at ZERO cost to taxpayers.
We recommend extending the SBA 504 loan refinance program and the First Mortgage Lien Pool (FMLP) program by at least one year each. Both of these temporary (24-month) programs were passed as part of the Small Business Jobs and Credit Act of September 2010, however, they were both subjected to severe delays, which has hampered their utilization and impact for the small business sector of our economy. These delays of nearly 14 months, in the case of SBA 504 refinance, and nearly 19 months, in the case of FMLP, greatly harmed their rollout.
The reason an extension of these two programs will bring down the subsidy rate is because both charge higher fees to borrowers to offset future losses (16.55 additional basis points for 504 refinance and 74.40 additional basis points for FMLP — neither program was subject to the same statutory fee limitation in the regular 504 program). But based on my personal experience in the industry and with very limited historical data on 504 refinances, I believe these fees are grossly overstated and hence will produce excess fees to help bring down the subsidies for the 504 loan program in the coming years. These additional fees are enlarging the future pool set aside for losses; thus, to let these programs expire shortly (in September 2012) as they are now gaining momentum and meeting the needs of the small business credit marketplace, would be unwise and irresponsible.
Nationwide, the 504 refinance loan volume confirms there is a healthy demand for these loans, even with the higher fees. According to recent data I have received from Mark Quinn, the SBA District Director for the San Francisco District Office, SBA 504 refinances have amounted to 14.7% of the number of 504 loans made in the First Quarter of 2012 and 20.6% of the total SBA 504 dollars nationally. This compares with just 3.9% of the total numbers and 5.3% of the total dollars nationally in all of 2011. In other words, the SBA 504 refinance program is accelerating since the Agency’s final regulations were released in mid-October of 2011, only five months ago.
In today’s reality of more stringent banking regulations, many performing loans (making their payments) are being declined for refinancing. This is not because these borrowers are missing payments or need a bail out — it is simply caused by the drop in commercial real estate values and the negative impact that drop has had on banks’ loan to value ratio requirements. In the end, the ability to offer the 504 loan refinance program to these performing borrowers is often the only option available to these businesses. Further, this option provides lenders an opportunity to help their borrowers stay in business, maintain the jobs and keep a performing loan on the bank’s books.
The Office of Management and Budget (OMB) recently released a “Subsidy Reestimate” of the Federal Credit Supplement. In Table 8, “Loan Guarantees: Subsidy Reestimates,” it showed the 504 refinance loan subsidy rate would jump from 0% to 6.67% for FY 2013. My experience does not indicate that such a radical jump is necessary, and I question how this figure was formulated. I suggest, and my experience thus far confirms, that the default rate on the 504 refinance loans will remain very low. Please keep in mind that the refinance loans are only for performing loans (startups, a higher-risk category of borrowers, were automatically excluded), ones that are currently meeting their monthly payments — this, along with several other risk-mitigating parameters, were clarified by the Agency. Furthermore, most are paying less each month with the historical, low 504 refinance rates now available and a longer-term loan, when reamortizing their loan. I suggest these parameters in fact make the 504 refinance loan borrower stronger and less of a risk than even current, traditional 504 loan borrowers. Opposition to extending the 504 refinance based on equating it with other recent residential loan modification programs is based on faulting reasoning and creating a completely invalid analogy.
The small business credit markets, while somewhat “thawing” currently for multi-use, owner-occupied commercial property, have yet to begin thawing for credit-worthy special-purpose commercial property types (such as limited-service hotels, restaurants, daycares, assisted-living facilities, and so forth), all of which are currently being financed with FMLP and thereby injecting additional liquidity into the small business credit marketplace for other capital access purposes. In creating the FMLP, the Agency rightly recognized they could actually lower their risk profile by taking preferential risk (guaranteeing a first lien, in addition to their second lien position), while aiding capital access with this secondary market for 504 first liens. Restricting 504 loans now (by not extending these 504 programs) could exert downward pressure on a modestly recovering commercial property market, not to mention further restrict capital access to small businesses.
Solution: EXTEND the 504 refinance and FMLP programs by a minimum of one year.
3.) Extra Measures
We call these “extra measures” because while they would both have a significant impact on the subsidies, we consider these to be worst-case solutions and only include them as a demonstration of intellectual honesty. These solutions would be to lower the SBA 504 loan program authority dollars and increase borrower fees above their statutory maximum.
Lower. By slightly reducing the yearly allocated lending authority for the SBA 504 loan program, the necessary subsidy will also go down. For instance, lowering the authority to $5 billion (from $6 billion proposed) will lower the estimated subsidy from $113 million to $94.166 million (a reduction of $18.834 million or 16.67% less). Although this is not ideal, as we would prefer not to see any decrease to the authority limits on the SBA 504 loan program, we clearly understand the importance of reducing, or ideally eliminating, the subsidy requirements for the program. The 504 program is much more stable as a self-funded program. Additionally, through this tough economic climate, we do see less traditional 504 loans and feel strongly that the extension of the refinance loan and FMLP programs would keep the 504 loan program available to many small businesses in desperate need of capital access financing. Furthermore, we see this as a temporary measure that will reverse itself over the next few years as the subsidy rate naturally declines.
Raise. By slightly raising the borrower guarantee fee from the current statutory limit of 0.9375, we could allow borrowers to continue covering the cost of the program and again stabilize the entire 504 loan program. The amount of increase to borrowers does not have to be significant and would likely not deter any qualified borrowers from utilizing the program. However, this could be a minimal increase if it is coupled with some of the concepts previously mentioned in this document. For ease, we would suggest these be raised to match the 504 refinance fee level (1.103) versus the current statutory maximum (0.9375). This increase of 16.55 basis points would result in a reduction of the estimated $113 million subsidy to $103.07 million (a reduction of $9.93 million or 8.78% less). Again, this is not an ideal strategy, but given that it should be temporary, it is well worth investigating to ensure the subsidy rate is ultimately reduced.
Three E’s: Empowerment, Extension, and Extra Measures. These are the three ways that the SBA 504 loan program can become zero-subsidy once again. I urge the Committee to consider these recommended solutions, particularly Extending the 504 refinance program, Extending the FMLP program, and Empowering CDCs to become more involved in the recovery process. Please take action on these expeditiously.
Thank you, once again, for your time and consideration.
Christopher G. Hurn,
CEO and Cofounder
Mercantile Capital Corporation