Small Business Administration: 7(a) Loan Program Needs Additional
Performance Measures (01-NOV-07, GAO-08-226T).			 
                                                                 
The Small Business Administration's (SBA) 7(a) program, initially
established in 1953, provides loan guarantees to small businesses
that cannot obtain credit in the conventional lending market. In 
fiscal year 2006, the program assisted more than 80,000 	 
businesses with loan guarantees of nearly $14 billion. This	 
testimony, based on a 2007 report, discusses (1) the 7(a)	 
program's purpose and the performance measures SBA uses to assess
the program's results; (2) evidence of any market constraints	 
that may affect small businesses' access to credit in the	 
conventional lending market; (3) the segments of the small	 
business lending market that were served by 7(a) loans and the	 
segments that were served by conventional loans; and (4) 7(a)	 
program's credit subsidy costs and the factors that may cause	 
uncertainty about these costs.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-226T					        
    ACCNO:   A77890						        
  TITLE:     Small Business Administration: 7(a) Loan Program Needs   
Additional Performance Measures 				 
     DATE:   11/01/2007 
  SUBJECT:   Cost analysis					 
	     Government guaranteed loans			 
	     Interest rates					 
	     Lending institutions				 
	     Loan interest rates				 
	     Performance measures				 
	     Program evaluation 				 
	     Program management 				 
	     Risk assessment					 
	     Small business					 
	     Small business assistance				 
	     Small business loans				 
	     Strategic planning 				 
	     Subsidies						 
	     Program costs					 
	     Program goals or objectives			 
	     Program implementation				 
	     SBA 7(a) Loan Program				 

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GAO-08-226T

   

     * [1]Background
     * [2]The 7(a) Program's Policy Objectives Reflect Legislative His
     * [3]Limited Evidence Suggests That Certain Market Imperfections
     * [4]A Higher Percentage of 7(a) Loans Went to Certain Segments o
     * [5]Current Reestimates Show Lower-Than-Expected Subsidy Costs,
     * [6]Contacts and Staff Acknowledgments

          * [7]Order by Mail or Phone

Testimony

Before the Subcommittee on Federal Financial Management, Government
Information, Federal Services, and International Security, Committee on
Homeland Security and Governmental Affairs, U.S. Senate

United States Government Accountability Office

GAO

For Release on Delivery
Expected at 2:00 p.m. EDT
Thursday, November 1, 2007

SMALL BUSINESS ADMINISTRATION

7(a) Loan Program Needs Additional Performance Measures

Statement of William B. Shear, Director Financial Markets and Community
Investment

GAO-08-226T

Mr. Chairman and Members of the Subcommittee:

I am pleased to have the opportunity to be here today to discuss the Small
Business Administration's (SBA) 7(a) loan program. Initially established
in 1953, the 7(a) program guarantees loans made by commercial
lenders--mostly banks--to small businesses for working capital and other
general business purposes.^1 As the agency's largest loan program for
small businesses, the 7(a) program is intended to help these businesses
obtain credit that they cannot secure in the conventional lending market.
For example, because they may lack the financial and other information
that larger, more established firms can provide, some small businesses may
be unable to obtain credit from conventional lenders. The guarantee
provided through the 7(a) program assures lenders that they will receive
an agreed-upon portion (generally between 50 percent and 85 percent) of
the outstanding balance if a borrower defaults on a loan. Because the
guarantee covers a portion of the outstanding amount, lenders and SBA
share some of the risk associated with a potential default, decreasing the
lender's risk and potentially making make more credit available to small
businesses. In fiscal year 2006, the 7(a) program assisted slightly more
than 80,000 businesses by guaranteeing loans valued at nearly $14 billion.

In my testimony, I will discuss the findings from our recent report on the
SBA's 7(a) loan program.^2 Specifically, my testimony addresses (1) the
7(a) program's purpose and the performance measures SBA uses to assess the
program's results; (2) evidence of any market constraints that may affect
small businesses' access to credit in the conventional lending market; (3)
the segments of the small business lending market that are served by 7(a)
loans and the segments that are served by conventional loans; and (4) the
7(a) program's credit subsidy costs and the factors that may cause
uncertainty about the 7(a) program's cost to the federal government.

In conducting this work, we reviewed the program's underlying statutes and
legislative history. We compared the measures that SBA uses to assess the
performance of the 7(a) program to criteria that we developed for
successful performance measures and interviewed SBA officials on the
agency's efforts to improve its performance measures. In addition, we
summarized peer-reviewed studies on market imperfections in the lending
market. Relying on SBA data from 2001 through 2004 and on the Federal
Reserve's 2003 Survey of Small Business Finances (SSBF), we compared
characteristics and loan terms of 7(a) borrowers to those of small
business borrowers.^3 Finally, we compared SBA's original credit subsidy
cost estimates for fiscal years 1992 through 2006 to SBA's current
reestimates, (as reported in the fiscal year 2008 Federal Credit
Supplement) and interviewed SBA officials about the differences.^4 We
conducted our work in Washington, D.C., and Chicago between May 2006 and
July 2007 in accordance with generally accepted government auditing
standards.

^1Section 7(a) of the Small Business Act, as amended, codified at 15
U.S.C. S 636(a); see also 13 C.F.R. Part 120. Although SBA has limited
legislative authority to make direct loans to borrowers that are unable to
obtain loans from conventional lenders, SBA has not received any funding
for these programs since fiscal year 1996.

^2GAO, Small Business Administration: Additional Measures Needed to Assess
7(a) Loan Program's Performance, GAO -07-769 (Washington, D.C: July 13,
2007).

In summary:

           o As the 7(a) program's underlying statutes and legislative
           history suggest, the loan program's purpose is to help small
           businesses obtain credit. The 7(a) program's design reflects this
           legislative history, but the performance measures provide limited
           information about the impact of the loans on participating small
           businesses. The underlying statutes and legislative history of the
           7(a) program help establish the federal government's role in
           assisting and protecting the interests of small businesses,
           especially those with minority ownership. The program's
           performance measures focus on indicators that are primarily output
           measures--for instance, they report on the number of loans
           approved and funded. But none of the measures looks at how well
           firms do after receiving 7(a) loans, so no information is
           available on outcomes. As a result, the current measures do not
           indicate how well the agency is meeting its strategic goal of
           helping small businesses succeed. The agency is currently
           undertaking efforts to develop additional, outcome-based
           performance measures for the 7(a) program, but agency officials
           said that it was not clear when these measures might be introduced
           or what they might measure.
			  
^3The Board of Governors of the Federal Reserve System's (Federal Reserve)
SSBF is the best available data on loans made to small firms in the
conventional lending market. Firms eligible for the SSBF include
for-profit, nonagricultural, nondepository institutions, nongovernment
businesses in operation in December 2003 and during the interview, that
also had less than 500 employees. Information in the SSBF may include some
loans that were guaranteed by the 7(a) loan program.

^4Office of Management and Budget, Federal Credit Supplement, Budget of
the U.S. Government, Fiscal Year 2008 (Washington, D.C.: Feb. 5, 2007).

           o Limited evidence from economic studies suggests that some small
           businesses may face constraints in accessing credit because of
           imperfections such as credit rationing in the conventional lending
           market. Some studies showed, for example, that lenders might lack
           the information needed to distinguish between creditworthy and
           noncreditworthy borrowers and thus could "ration" credit by not
           providing loans to all creditworthy borrowers. Several studies we
           reviewed generally concluded that credit rationing was more likely
           to affect small businesses, because lenders could face challenges
           obtaining enough information on these businesses to assess their
           risk. However, the studies on credit rationing were limited
           because the researchers used different definitions of credit
           rationing and the literature relied on data from the early 1970s
           through the early 1990s. Data from this period does not account
           for recent trends in the small business lending market, such as
           the increasing use of credit scores, which may provide needed
           information and thus reduce credit rationing. Though studies we
           reviewed noted some disparities among borrowers with respect to
           race and gender in the conventional lending market, the studies
           did not offer conclusive evidence on the reasons for those
           differences.

           o 7(a) loans went to certain segments of the small business
           lending market in higher proportions than conventional loans from
           2001 to 2004. First, a higher percentage of 7(a) than conventional
           loans went to minority-owned and start-up businesses. For example,
           28 percent of 7(a) loans compared with an estimated 9 percent of
           conventional loans went to minority-owned small businesses from
           2001 through 2004. In addition, 25 percent of 7(a) loans went to
           small business start-ups, while the overall lending market served
           almost exclusively established firms (about 95 percent). However,
           more similar percentages of 7(a) and conventional loans went to
           other segments of the small business lending market, such as
           women-owned firms and those located in distressed neighborhoods.
           For example, 22 percent of 7(a) loans went to women-owned firms
           compared to an estimated 16 percent of conventional loans.
           Finally, the characteristics of 7(a) and conventional loans
           differed in several key respects. In particular, 7(a) loans
           typically were larger and more likely to have variable rates,
           longer maturities, and higher interest rates than conventional
           loans to small businesses.

           o SBA's current reestimates of the credit subsidy costs for 7(a)
           loans made during fiscal years 1992 through 2004 indicate that, in
           general, the long-term costs of these loans will be lower than
           initially estimated. Loan guarantee programs can result in subsidy
           costs to the federal government, and the Federal Credit Reform Act
           of 1990 (FCRA) requires, among other things, that agencies
           estimate the cost of the loan guarantees to the federal
           government. SBA makes its best initial estimate of the 7(a)
           program's credit subsidy costs and revises the estimate annually
           as new information becomes available. Starting in fiscal year
           2005, SBA estimated that the credit subsidy cost of the 7(a)
           program would be equal to zero--that is, the program would no
           longer require annual appropriations of budget authority. To
           offset some of the costs of the program, such as default costs,
           SBA adjusted a fee paid annually by lenders that are based on the
           outstanding portion of the guaranteed loan so that the initial
           credit subsidy estimates would be zero (based on expected loan
           performance). However, the most recent reestimates, including
           those made since 2005, may change. Any changes would reflect the
           inherent uncertainties of forecasting subsidy costs and the
           influence of economic conditions such as interest rates on several
           factors, including loan defaults (which exert the most influence
           over projected costs) and prepayment rates. Unemployment, which
           related to the condition of the national economy, could also
           affect the credit subsidy cost--for instance, if unemployment
           rises above projected levels, loan defaults are likely to
           increase.

           o Our recent report made a recommendation to SBA that was intended
           to help ensure that the 7(a) program was meeting its mission
           responsibility of helping small firms succeed through guaranteed
           loans. Specifically, we recommended that SBA complete and expand
           its current work on evaluating the program's performance measures
           and use the loan performance information it already collects,
           including defaults and prepayment rates, to better report how
           small businesses fare after they participate in the 7(a) program.
           SBA concurred with the recommendation but has not yet told us how
           the agency intends to implement it.

           o Finally, SBA disagreed with our analysis that showed limited
           differences in credit scores between small businesses that
           accessed credit without SBA assistance and those that received
           7(a) loans. We believe that our analysis of credit scores provides
           a reasonable basis for comparison. As SBA noted in its comments,
           we disclosed the limitations of the analysis and noted the need
           for some caution in interpreting the results. Taking into account
           these limitations, we believe that future comparisons of
           comparable credit score data for small business borrowers may
           provide SBA with a more conclusive picture of the relative
           riskiness of 7(a) and conventional borrowers, consistent with the
           intent of our recommendation.
			  
			  Background

           To be eligible for the 7(a) loan program, a business must be an
           operating for-profit small firm (according to SBA's size
           standards) located in the United States. To determine whether a
           business qualifies as small for the purposes of the 7(a) program,
           SBA uses size standards that it has established for each industry.
           SBA relies on the lenders that process and service 7(a) loans to
           ensure that borrowers meet the program's eligibility
           requirements.^5 In addition, lenders must certify that small
           businesses meet the "credit elsewhere" requirement. SBA does not
           extend credit to businesses if the financial strength of the
           individual owners or the firm itself is sufficient to provide or
           obtain all or part of the financing the firm needs or if the
           business can access conventional credit. To certify borrowers as
           having met the credit elsewhere requirement, lenders must first
           determine that the firm's owners are unable to provide the desired
           funds from their personal resources. Second, lenders must
           determine that the business cannot secure the desired credit for
           similar purposes and the same period of time on reasonable terms
           and conditions from nonfederal sources (lending institutions)
           without SBA assistance, taking into account the prevailing rates
           and terms in the community or locale where the firm conducts
           business.

           According to SBA's fiscal year 2003-2008 Strategic Plan, the
           agency's mission is to maintain and strengthen the nation's
           economy by enabling the establishment and viability of small
           businesses and by assisting in the economic recovery of
           communities after disasters. SBA describes the 7(a) program as
           contributing to an agencywide goal to "increase small business
           success by bridging competitive opportunity gaps facing
           entrepreneurs." As reported annually in SBA's Performance and
           Accountability Reports (PAR), the 7(a) program contributes to this
           strategic goal by fulfilling each of the following three
           long-term, agencywide objectives:

           o increasing the positive impact of SBA assistance on the number
           and success of small business start-ups,

           o maximizing the sustainability and growth of existing small
           businesses that receive SBA assistance, and
			  
^5Within the 7(a) program, there are several program delivery
methods--regular 7(a), the certified lender program, the preferred lender
program, SBAExpress, Community Express, Export Express, and Patriot
Express. SBA provides final approval for loans made under the regular 7(a)
program. Certified lenders must perform a thorough credit analysis on the
loan application packages they submit to SBA that SBA can use to perform a
credit review, shortening the loan processing time. Preferred lenders have
delegated authority to make SBA-guaranteed loans, subject only to a brief
eligibility review and assignment of a loan number by SBA. Lenders
participating in SBAExpress, Community Express, Export Express, and
Patriot Express also have delegated authority to make SBA-guaranteed
loans.			  

           o significantly increasing successful small business ownership
           within segments of society that face special competitive
           opportunity gaps.

           Groups facing these special competitive opportunity gaps include
           those that SBA considers to own and control little productive
           capital and to have limited opportunities for small business
           ownership (such as African Americans, American Indians, Alaska
           Natives, Hispanics, Asians, and women) and those that are in
           certain rural or low-income areas. For each of its three long-term
           objectives, SBA collects and reports on the number of loans
           approved, the number of loans funded (i.e., money that was
           disbursed), and the number of firms assisted.

           Loan guarantee programs can result in subsidy costs to the federal
           government, and the Federal Credit Reform Act of 1990 (FCRA)
           requires, among other things, that agencies estimate the cost of
           these programs--that is, the cost of the loan guarantee to the
           federal government. In recognizing the difficulty of estimating
           credit subsidy costs and acknowledging that the eventual cost of
           the program may deviate from initial estimates, FCRA requires
           agencies to make annual revisions (reestimates) of credit subsidy
           costs for each cohort of loans made during a given fiscal year
           using new information about loan performance, revised expectations
           for future economic conditions and loan performance, and
           improvements in cash flow projection methods. These reestimates
           represent additional costs or savings to the government and are
           recorded in the budget. FCRA provides that reestimates that
           increase subsidy costs (upward reestimates), when they occur, be
           funded separately with permanent indefinite budget authority.^6 In
           contrast, reestimates that reduce subsidy costs (downward
           reestimates) are credited to the Treasury and are unavailable to
           the agency. In addition, FCRA does not count administrative
           expenses against the appropriation for credit subsidy costs.
           Instead, administrative expenses are subject to separate
           appropriations and are recorded each year as they are paid, rather
           than as loans are originated.

^6Permanent, indefinite budget authority is available as a result of
previously enacted legislation (in this case, FCRA) and is available
without further legislative action or until Congress affirmatively
rescinds the authority. The amount of the budget authority is
indefinite--that is, unspecified at the time of enactment--but becomes
determinable at some future date (in this case, when reestimates are
made).

           The 7(a) Program's Policy Objectives Reflect Legislative History,
			  but Its Performance Measures Do Not Gauge the Program's Impact on
			  Participating Firms

           The legislative basis for the 7(a) program recognizes that the
           conventional lending market is the principal source of financing
           for small businesses and that the loan assistance that SBA
           provides is intended to supplement rather than compete with that
           market. The design of the 7(a) program has SBA collaborating with
           the conventional market in identifying and supplying credit to
           small businesses in need of assistance. Specifically, we highlight
           three design features of the 7(a) program that help it address
           concerns identified in its legislative history. First, the loan
           guarantee, which plays the same role as collateral, limits the
           lender's risk in extending credit to a small firm. Second, the
           "credit elsewhere" requirement is intended to provide some
           assurance that guaranteed loans are offered only to firms that are
           unable to access credit on reasonable terms and conditions in the
           conventional lending market. Third, an active secondary market for
           the guaranteed portion of a 7(a) loan allows lenders to sell the
           guaranteed portion of the loan to investors, providing additional
           liquidity that lenders can use for additional loans.

           Furthermore, numerous amendments to the Small Business Act and to
           the 7(a) program have laid the groundwork for broadening small
           business ownership among certain groups, including veterans,
           handicapped individuals, and women, as well as among persons from
           historically disadvantaged groups, such as African Americans,
           Hispanic Americans, Native Americans, and Asian Pacific Americans.
           The 7(a) program also includes provisions for extending financial
           assistance to small businesses that are located in urban or rural
           areas with high proportions of unemployed or low-income
           individuals or that are owned by low-income individuals. The
           program's legislative history highlights its role in, among other
           things, helping small businesses get started, allowing existing
           firms to expand, and enabling small businesses to develop foreign
           markets for their products and services.

           All nine performance measures we reviewed provided information
           that related to the 7(a) loan program's core activity, which is to
           provide loan guarantees to small businesses. In particular, the
           indicators all provided the number of loans approved, loans
           funded, and firms assisted across the subgroups of small
           businesses the 7(a) program was intended to assist.

           We have stated in earlier work that a clear relationship should
           exist between an agency's long-term strategic goals and its
           program's performance measures.^7 Outcome-based goals or measures
           showing a program's impact on those it serves should be included
           in an agency's performance plan whenever possible. However, all of
           the 7(a) program's performance measures are primarily output
           measures. SBA does not collect any outcome-based information that
           discusses how well firms are doing after receiving a 7(a) loan.
           Further, none of the measures link directly to SBA's long-term
           objectives. As a result, the performance measures do not fully
           support SBA's strategic goal of increasing the success of small
           businesses by "bridging competitive opportunity gaps facing
           entrepreneurs."

           SBA officials have recognized the importance of developing
           performance measures that better assess the 7(a) program's impact
           on the small firms that receive the guaranteed loans. SBA is still
           awaiting a final report, originally expected sometime during the
           summer of 2007, from the Urban Institute, which has been
           contracted to undertake several evaluative studies of various SBA
           programs, including 7(a), that provide financial assistance to
           small businesses.

           SBA officials explained that, for several reasons, no formal
           decision had yet been made about how the agency might alter or
           enhance the current set of performance measures to provide more
           outcome-based information related to the 7(a) program. The reasons
           given included the agency's reevaluation of its current strategic
           plan in response to requirements in the Government Performance and
           Results Act of 1993 that agencies reassess their strategic plans
           every 3 years, a relatively new administrator who may make changes
           to the agency's performance measures and goals, and the cost and
           legal constraints associated with the Urban Institute study.
           However, SBA already collects information showing how firms are
           faring after they obtain a guaranteed loan. In particular, SBA
           regularly collects information on how well participating firms are
           meeting their loan obligations. This information generally
           includes, among other things, the number of firms that have
           defaulted on or prepaid their loans--data that could serve as
           reasonable proxies for determining a firm's financial status.
           However, the agency primarily uses the data to estimate some of
           the costs associated with the program and for internal reporting
           purposes, such as monitoring participating lenders and analyzing
           its current loan portfolio. Using this information to expand its
           performance measures could provide SBA and others with helpful
           information about the financial status of firms that have been
           assisted by the 7(a) program.
			  
^7Some earlier work includes GAO, Executive Guide: Effectively
Implementing the Government Performance and Results Act, [8]GAO/GGD-96-118
(Washington, D.C.: June 1996); and GAO, The Results Act: An Evaluator's
Guide to Assessing Agency Annual Performance Plans, GAO/GGD-10.1.120
(Washington, D.C.: April 1998).

           To better ensure that the 7(a) program is meeting its mission
           responsibility of helping small firms succeed through guaranteed
           loans, we recommended in our report that SBA complete and expand
           its current work on evaluating the 7(a) program's performance
           measures. As part of this effort, we indicated that, at a minimum,
           SBA should further utilize the loan performance information it
           already collects, including but not limited to defaults,
           prepayments, and number of loans in good standing, to better
           report how small businesses fare after they participate in the
           7(a) program. In its written response, SBA concurred with our
           recommendation.
			  
			  Limited Evidence Suggests That Certain Market Imperfections May
			  Restrict Access to Credit for Some Small Businesses

           We found limited information from economic studies that credit
           constraints such as credit rationing could have some effect on
           small businesses in the conventional lending market. Credit
           rationing, or denying loans to creditworthy individuals and firms,
           generally stems from lenders' uncertainty or lack of information
           regarding a borrower's ability to repay debt. Economic reasoning
           suggests that there exists an interest rate--that is, the price of
           a loan--beyond which banks will not lend, even though there may be
           creditworthy borrowers willing to accept a higher interest rate.^8
           Because the market interest rate will not climb high enough to
           convince lenders to grant credit to these borrowers, these
           applicants will be unable to access credit and will also be left
           out of the lending market.^9 Of the studies we identified that
           empirically looked for evidence of this constraint within the
           conventional U.S. lending market, almost all provided some
           evidence consistent with credit rationing. For example, one study
           found evidence of credit rationing across all sizes of firms.^10
           However, another study suggested that the effect of credit
           rationing on small firms was likely small, and another study
           suggested that the impact on the national economy was not likely
           to be significant.^11
			  
^8For more details on how economic theory predicts credit rationing, see
J.E. Stiglitz and A. Weiss, "Credit Rationing in Markets with Imperfect
Information," The American Economic Review, vol. 71, no.3 (1981).

^9However, under certain circumstances, economic reasoning suggests that
lack of information about certain types of borrowers could result in the
opposite--an excess of credit. See D. DeMeza and D.C. Webb, "Too Much
Investment: A Problem of Asymmetric Information," The Quarterly Journal of
Economics, vol. 102, no. 2 (1987).

^10S. J. Perez, "Testing for Credit Rationing: An Application of
Disequilibrium Econometrics," Journal of Macroeconomics, vol. 20, no. 4
(1998).

^11A. R. Levison and Kristen L. Willard, "Do Firms Get the Financing They
Want? Measuring Credit Rationing Experienced by Small Businesses in the
U.S.," Small Business Economics, vol. 14, no. 2 (2000); and A. N. Berger
and G. F. Udell, "Some Evidence on the Empirical Significance of Credit
Rationing," The Journal of Political Economy, vol. 100, no. 5 (1992).		  

           Because the underlying reason for having been denied credit can be
           difficult to determine, true credit rationing is difficult to
           measure. In some studies we reviewed, we found that researchers
           used different definitions of credit rationing, and we determined
           that a broader definition was more likely to yield evidence of
           credit rationing than a narrower definition. For example, one
           study defined a firm facing credit rationing if it had been denied
           a loan or discouraged from applying for credit.^12 However,
           another study pointed out that firms could be denied credit for
           reasons other than credit rationing--for instance, for not being
           creditworthy.^13 Other studies we reviewed that studied small
           business lending found evidence of credit rationing by testing
           whether the circumstances of denial were consistent with a "credit
           rationing" explanation such as a lack of information. Two studies
           concluded that having a preexisting relationship with the lender
           had a positive effect on the borrower's chance of obtaining a
           loan.^14 The empirical evidence from another study suggested that
           lenders used information accumulated over the duration of a
           financial relationship with a borrower to define loan terms. ^15
           This study's results suggested that firms with longer
           relationships received more favorable terms--for instance, they
           were less likely to have to provide collateral. Because having a
           relationship with a borrower would lead to the lender's having
           more information, the positive effect of a preexisting
           relationship is consistent with the theory behind credit
           rationing.

^12J. Berkowitz and M. J. White, "Bankruptcy and Small Firms' Access to
Credit," The RAND Journal of Economics, vol. 35, no. 1 (2004).

^13Levinson and Willard, "Do Firms Get the Financing They Want?"

^14M. A. Petersen and R. G. Rajan, "The Benefits of Lending Relationships:
Evidence from Small Business Data," The Journal of Finance, vol. 49, no. 1
(1994); and R. A. Cole, "The Importance of Relationships to the
Availability of Credit," Journal of Banking and Finance, vol. 22 (1998).

^15A. N. Berger and G. F. Udell, "Relationship Lending and Lines of Credit
in Small Firm Finance," The Journal of Business, vol. 68, no. 3 (1995).
 
           However, the studies we reviewed regarding credit rationing used
           data from the early 1970s through the early 1990s and thus did not
           account for several recent trends that may have impacted, either
           positively or negatively, the extent of credit rationing within
           the small business lending market. These trends include, for
           example, the increasing use of credit scores, changes to
           bankruptcy laws, and consolidation in the banking industry.

           Discrimination on the basis of race or gender may also cause
           lenders to deny loans to potentially creditworthy firms.
           Discrimination would also constitute a market imperfection,
           because lenders would be denying credit for reasons other than
           interest rate or another risk associated with the borrower. A 2003
           survey of small businesses conducted by the Federal Reserve
           examined differences in credit use among racial groups and between
           genders.^16 The survey found that 48 percent of small businesses
           owned by African Americans and women and 52 percent of those owned
           by Asians had some form of credit, while 61 percent of white- and
           Hispanic-owned businesses had some form of credit.^17 Studies have
           attempted to determine whether such disparities are due to
           discrimination, but the evidence from the studies we reviewed was
           inconclusive.
			  
			  A Higher Percentage of 7(a) Loans Went to Certain Segments of the
			  Small Business Lending Market, but Conventional Loans Were Widely
			  Available

           Certain segments of the small business lending market received a
           higher share of 7(a) loans than of conventional loans between 2001
           to 2004, including minority-owned businesses and start-up firms.
           More than a quarter of 7(a) loans went to small businesses with
           minority ownership, compared with an estimated 9 percent of
           conventional loans (fig. 1). However, in absolute numbers many
           more conventional loans went to the segments of the small business
           lending market we could measure, including minority-owned small
           businesses, than loans with 7(a) guarantees.^18
			  
^16T. L. Mach and J. D. Wolken, "Financial Services Used by Small
Businesses: Evidence from the 2003 Survey of Small Business Finances,"
Federal Reserve Bulletin Oct.: A167-A195 (2006).

^17The survey question specifically asked respondents about having a
credit line, loan, or capital lease.

^18For example, we estimate that in 2004 approximately 62,000 outstanding
7(a) loans went to minority-owned firms, while there were more than 1.6
million outstanding loans to minority-owned small businesses from the
conventional lending market.			  

           Figure 1: Percentage of 7(a) and Conventional Loans by Minority
           Status of Ownership, 2001-2004

           Note: The brackets on the conventional loans represent confidence
           intervals. Because the data from SSBF are from a probability
           survey based on random selections, this sample is only one of a
           large number of samples that might have been drawn. Since each
           sample could have provided different estimates, we express our
           confidence in the precision of the particular results as a
           95-percent confidence interval. This is the interval that would
           contain the actual population value for 95 percent of the samples
           that could have been drawn. As a result, we are 95-percent
           confident that each of the confidence intervals will include the
           true values in the study population. Information on SBA 7(a) loans
           does not have confidence intervals, because we obtained data on
           all the loans SBA approved and disbursed from 2001 to 2004.

           Compared with conventional loans, a higher percentage of 7(a)
           loans went to small new (that is, start-up) firms from 2001
           through 2004 (fig. 2). Specifically, 25 percent of 7(a) loans went
           to small business start-ups, in contrast to an estimated 5 percent
           of conventional loans that went to newer small businesses over the
           same period.

           Figure 2: Percentage of 7(a) and Conventional Loans by Status as a
           New Business, 2001-2004

           Note: The brackets on the conventional loans represent a
           95-percent confidence interval.

           Only limited differences exist between the shares of 7(a) and
           conventional loans that went to other types of small businesses
           from 2001 through 2004. For example, 22 percent of all 7(a) loans
           went to small women-owned firms, compared with an estimated 16
           percent of conventional loans that went to these firms. The
           percentages of loans going to firms owned equally by men and women
           were also similar--17 percent of 7(a) loans and an estimated 14
           percent of conventional loans (fig. 3). However, these percentages
           are small compared with those for small firms headed by men, which
           captured most of the small business lending market from 2001 to
           2004. These small businesses received 61 percent of 7(a) loans and
           an estimated 70 percent of conventional loans.

           Figure 3: Percentage of 7(a) and Conventional Loans by Gender of
           Ownership, 2001-2004

           Note: The brackets on the conventional loans represent a
           95-percent confidence interval.

           Similarly, relatively equal shares of 7(a) and conventional loans
           reached small businesses in economically distressed neighborhoods
           (i.e., zip code areas) from 2001 through 2004--14 percent of 7(a)
           loans and an estimated 10 percent of conventional loans.^19 SBA
           does not specifically report whether a firm uses its 7(a) loan in
           an economically distressed neighborhood but does track loans that
           go to firms located in areas it considers "underserved" by the
           conventional lending market.^20 SBA's own analysis found that 49
           percent of 7(a) loans approved and disbursed in fiscal year 2006
           went to these geographic areas.

^19We defined distressed neighborhoods as zip code areas where at least 20
percent of the population had incomes below the national poverty line.

^20These include the following federally defined areas: Historically
Underutilized Business Zone, Empowerment Zone/Enterprise Community, low-
and moderate-income census tract (median income of census tract is no
greater than 80 percent of the associated metropolitan area or
nonmetropolitan median income), or rural (as classified by the U.S.
Census).

           A higher proportion of 7(a) loans (57 percent) went to smaller
           firms (that is, firms with up to five employees), compared with an
           estimated 42 percent of conventional loans. As the number of
           employees increased, differences in the proportions of 7(a) and
           conventional loans to firms with similar numbers of employees
           decreased. Also, similar proportions of 7(a) and conventional
           loans went to small businesses with different types of
           organizational structures and in different geographic locations.

           Our analysis of information on the credit scores of small
           businesses that accessed credit without SBA assistance showed only
           limited differences between these credit scores and those of small
           firms that received 7(a) loans. As reported in a database
           developed by two private business research and information
           providers, The Dun & Bradstreet Corporation and Fair Isaac
           Corporation (D&B/FIC), the credit scores we compared are typically
           used to predict the likelihood that a borrower, in this case a
           small business, will repay a loan. ^21 In our comparison of firms
           that received 7(a) loans and those that received conventional
           credit, we found that for any particular credit score band (e.g.,
           160 to <170) the differences were no greater than 5 percentage
           points. The average difference for these credit score bands was
           1.7 percentage points (fig. 4). More credit scores for 7(a)
           borrowers were concentrated in the lowest (i.e., more risky) bands
           compared with general borrowers, but most firms in both the 7(a)
           and the D&B/FIC portfolios had credit scores in the same range
           (from 170 to <200). Finally, the percentage of firms that had
           credit scores in excess of 210 was less than 1 percent for both
           groups.
			  
^21The portfolio management score used by SBA is the Small Business
Predictive Score (SBPS). The SBPS is based on consumer and business data
and assigns scores to small businesses in the absolute range of 1 to 300,
but the practical range of 50 to 250. A lower score generally indicates a
greater likelihood of repayment risk, while a higher score indicates a
greater likelihood that the loan will be repaid.

Figure 4: Percentage of Small Business Credit Scores (2003-2006) for Firms
That Received 7(a) and Conventional Credit in D&B/FIC Sample (1996-2000),
by Credit Score Range

The results our analysis of credit scores should be interpreted with some
caution. First, the time periods for the two sets of credit scores are
different. Initial credit scores for businesses receiving 7(a) loans in
our analysis are from 2003 to 2006.^22 The scores developed by D&B/FIC for
small businesses receiving conventional credit are based on data from 1996
through 2000 that include information on outstanding loans that may have
originated during or many years before that period.^23 Second, D&B/FIC's
scores for small businesses receiving conventional loans may not be
representative of the population of small businesses. Although D&B/FIC
combined hundreds of thousands of financial records from many lenders and
various loan products with consumer credit data for their credit score
development sample, they explained that the sample was not statistically
representative of all small businesses.

^22SBA says it first received SBPS credit scores for the outstanding 7(a)
loans in its portfolio in March 2003. Since then, SBA has received an
initial score, known as the Surrogate Origination Score, for a 7(a) loan 1
to 4 months after the loan is disbursed. SBA subsequently has received
SBPS scores on a quarterly basis for almost all of the active loans in its
portfolio. We obtained data for all 7(a) loans approved and disbursed from
2001 through 2005, so the dates of the initial credit scores ranged from
2003 to 2006.

^23The earlier period of credit scores for firms that obtained credit in
the conventional lending market represents data D&B/FIC had readily
available and could provide to us.

Another score developed by D&B, called the Financial Stress Score (FSS),
gauges the likelihood that a firm will experience financial stress--for
example, that it will go out of business.^24 SBA officials said that based
on analyses of these scores, the difference in the repayment risk of
lending associated with 7(a) loans was higher than the risk posed by small
firms able to access credit in the conventional lending market. According
to an analysis D&B performed based on these scores, 32 percent of 7(a)
firms showed a moderate to high risk of ceasing operations with unpaid
obligations in 2006, while only 17 percent of general small businesses had
a similar risk profile.

As already mentioned, SBA disagreed with the results of our credit score
comparison. In its written comments to our prior report, SBA primarily
reiterated the cautions included in our report and stated that the
riskiness of a portfolio was determined by the distribution in the riskier
credit score categories. SBA said that it had not worked out the numbers
but had concluded that the impact on loan defaults of the higher share of
7(a) loans in these categories would not be insignificant. Although SBA
disagreed with our results, we believe that our analysis of credit scores
provides a reasonable basis for comparison. Specifically, the data we used
were derived from a very large sample of financial transactions and
consumer credit data and reflected the broadest and most recent
information readily available to us on small business credit scores in the
conventional lending market. As SBA noted in its comments, we disclosed
the data limitations and necessary cautions to interpreting the credit
score comparison. Taking into consideration the limitations associated
with our analysis, future comparisons of comparable credit score data for
small business borrowers may provide SBA with a more conclusive picture of
the relative riskiness of borrowers with 7(a) and conventional loans,
which would also be consistent with the intent of our recommendation that
SBA develop more outcome-based performance measures.

^24The FSS predicts the likelihood that a business will cease operations
without paying creditors in full or that will go into receivership.

We also compared some of the characteristics of 7(a) and conventional
loans, including the size of the loans. In the smallest loan categories
(less than $50,000), a higher percentage of total conventional loans went
to small businesses--53 percent, compared with 39 percent of 7(a) loans.
Conversely, a greater percentage of 7(a) loans than conventional loans
were for large dollar amounts. For example, 61 percent of the number of
7(a) loans had dollar amounts in the range of more than $50,000 to $2
million (the maximum 7(a) loan amount), compared with an estimated 44
percent of conventional loans (fig. 5).

Figure 5: Percentage of 7(a) Loans and Conventional Loans by Loan Size,
2001-2004

Note: The brackets on the conventional loans represent a 95-percent
confidence interval. The maximum gross 7(a) loan amount is $2 million. The
dollar range categories on this chart reflect program thresholds for loan
amounts associated with different interest rates or guarantee fee levels.

Further, almost all 7(a) loans had variable interest rates and maturities
that tended to exceed those for conventional loans. Nearly 90 percent of
7(a) loans had variable rates compared with an estimated 43 percent of
conventional loans, and almost 80 percent of 7(a) loans had maturities of
more than 5 years, compared with an estimated 17 percent of conventional
loans (fig. 6).

Figure 6: Percentage of 7(a) and Conventional Loans by Loan Maturity
Category, 2001-2004

Note: The brackets on the conventional loans represent a 95-percent
confidence interval.

For loans under $1 million, interest rates were generally higher for 7(a)
loans than for conventional loans. From 2001 through 2004, quarterly
interest rates for the 7(a) program were, on average, an estimated 1.8
percentage points higher than interest rates for conventional loans (fig.
7).^25 Interest rates for small business loans offered in the conventional
market tracked the prime rate closely and were, on average, an estimated
0.4 percentage points higher.^26 Because the maximum interest rate allowed
by the 7(a) program was the prime rate plus 2.25 percent or more, over the
period the quarterly interest rate for 7(a) loans, on average, exceeded
the prime rate.^27

^25We used SBA data to calculate the calendar year and quarter in which
each loan was approved and to calculate interest rates for all loans in a
given quarter that were for under $1 million.

^26We used the Federal Reserve's Survey of Terms of Business Lending,
which provides information quarterly on commercial and industrial loans of
loans in four size categories (less than $100,000; from $100,000 through
$999,999; from $1 million through $999,999,000; and $10 million or more)
made only by commercial banks. We used only data related to the first two
categories because those loan amounts most resembled the 7(a) loans in the
SBA data and, as discussed previously, SBA considers loans reported in
call report data of $1 million or less to be for small businesses.

^27We used the Federal Reserve's historical reports on the monthly bank
prime rate to estimate the prime rate for every quarter from 2001 through
2004.

Figure 7: Interest Rate Comparison for Loans under $1 Million and Prime
Rate, 2001-2004

Current Reestimates Show Lower-Than-Expected Subsidy Costs, but Final Costs May
be Higher or Lower for Several Reasons

The current reestimated credit subsidy costs of 7(a) loans made during
fiscal years 1992 through 2004 generally are lower than the original
estimates, which are made at least a year before any loans are made for a
given fiscal year. Loan guarantees can result in subsidy costs to the
federal government, and the Federal Credit Reform Act of 1990 (FCRA)
requires, among other things, that agencies estimate the cost of the loan
guarantees to the federal government and revise its estimates (reestimate)
those costs annually as new information becomes available. The credit
subsidy cost is often expressed as a percentage of loan amounts--that is,
a credit subsidy rate of 1 percent indicates a subsidy cost of $1 for each
$100 of loans. As we have seen, the original credit subsidy cost that SBA
estimated for fiscal years 2005 and 2006 was zero, making the 7(a) program
a "zero credit subsidy" program--that is, the program no longer required
annual appropriations of budget authority. For loans made in fiscal years
2005 and 2006, SBA adjusted the ongoing servicing fee that it charges
participating lenders so that the initial subsidy estimate would be zero
based on expected loan performance at that time. Although the federal
budget recognizes costs as loans are made and adjusts them throughout the
lives of the loans, the ultimate cost to taxpayers is certain only when
none of the loans in a cohort remain outstanding and the agency makes a
final, closing reestimate. In addition to the subsidy costs, SBA incurs
administrative expenses for operating the loan guarantee program, though
these costs are appropriated separately from those for the credit subsidy.
In its fiscal year 2007 budget request, SBA requested nearly $80 million
to cover administrative costs associated with the 7(a) program.

Any forecasts of the expected costs of a loan guarantee program such as
7(a) are subject to change, since the forecasts are unlikely to include
all the changes in the factors that can influence the estimates. In part,
the estimates are based on predictions about borrowers' behavior--how many
borrowers will pay early or late or default on their loans and at what
point in time. According to SBA officials, loan defaults are the factor
that exerts the most influence on the 7(a) credit subsidy cost estimates
and are themselves influenced by various economic factors, such as the
prevailing interest rates. Since the 7(a) program primarily provides
variable rate loans, changes in the prevailing interest rates would result
in higher or lower loan payments, affecting borrowers' ability to pay and
subsequently influencing default and prepayment rates. For example, if the
prevailing interest rates fall, more firms could prepay their loans to
take advantage of lower interest rates, resulting in fewer fees for SBA.
Loan defaults could also be affected by changes in the national or a
regional economy. Generally, as economic conditions worsen--for example,
as unemployment rises--loan defaults increase. To the extent that SBA
cannot anticipate these changes in the initial estimates, it would include
them in the reestimates.

Mr. Chairman, this concludes my prepared statement. I would be pleased to
respond to any questions that you or other members of the Subcommittee may
have.

Contacts and Staff Acknowledgments

For additional information about this testimony, please contact William B.
Shear at (202) 512-8678 or [email protected]. Contact points for our Offices
of Congressional Affairs and Public Affairs may be found on the last page
of this statement. Individuals making key contributions to this testimony
included Benjamin Bolitzer, Emily Chalmers, Tania Calhoun, Daniel
Garcia-Diaz, Lisa Mirel, and Mijo Vodopic.

(250380)

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www.gao.gov/cgi-bin/getrpt? [15]GAO-08-226T .

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Highlights of [16]GAO-08-226T , a testimony before the Subcommittee on
Federal Financial Management, Government Information, Federal Services and
International Security, Committee on Homeland Security and Governmental
Affairs, U.S. Senate

November 2007

SMALL BUSINESS ADMINISTRATION

7(a) Loan Program Needs Additional Performance Measures

The Small Business Administration's (SBA) 7(a) program, initially
established in 1953, provides loan guarantees to small businesses that
cannot obtain credit in the conventional lending market. In fiscal year
2006, the program assisted more than 80,000 businesses with loan
guarantees of nearly $14 billion. This testimony, based on a 2007 report,
discusses (1) the 7(a) program's purpose and the performance measures SBA
uses to assess the program's results; (2) evidence of any market
constraints that may affect small businesses' access to credit in the
conventional lending market;  (3) the segments of the small business
lending market that were served by 7(a) loans and the segments that were
served by conventional loans; and (4) 7(a) program's credit subsidy costs
and the factors that may cause uncertainty about these costs.

[17]What GAO RecommendsIn the report discussed in this testimony, GAO
recommended that SBA complete and expand its work on evaluating 7(a)'s
performance measures and that SBA use the loan performance information it
collected, such as defaults rates, to better report how small businesses
fare after they participate in the program. SBA concurred with the
recommendation but disagreed with one comparison in a section of the
report on credit scores of small businesses with 7(a) and conventional
loans. GAO believes that its analysis provides a reasonable basis for
comparing these credit scores.

As the 7(a) program's underlying statutes and legislative history suggest,
the loan program's purpose is intended to help small businesses obtain
credit. The 7(a) program's design reflects this legislative history, but
the program's performance measures provide limited information about the
impact of the loans on participating small businesses. As a result, the
current performance measures do not indicate how well SBA is meeting its
strategic goal of helping small businesses succeed. The agency is
currently undertaking efforts to develop additional, outcome-based
performance measures for the 7(a) program, but agency officials said that
it was not clear when they might be introduced or what they might measure.

Limited evidence from economic studies suggests that some small businesses
may face constraints in accessing credit because of imperfections such as
credit rationing, in the conventional lending market. Several studies GAO
reviewed generally concluded that credit rationing was more likely to
affect small businesses because lenders could face challenges in obtaining
enough information on these businesses to assess their risk. However, the
studies on credit rationing were limited, in part, because the literature
relies on data from the early 1970s through the early 1990s, which do not
account for recent trends in the small business lending market, such as
the increasing use of credit scores. Though researchers have noted
disparities in lending options among different races and genders,
inconclusive evidence exists as to whether discrimination explains these
differences.

7(a) loans went to certain segments of the small business lending market
in higher proportions than conventional loans. For example, from 2001 to
2004 25 percent of 7(a) loans went to small business start-ups compared to
an estimated 5 percent of conventional loan. More similar percentages of
7(a) and conventional loans went to other market segments; 22 percent of
7(a) loans went to women-owned firms in comparison to an estimated 16
percent of conventional loans. The characteristics of 7(a) and
conventional loans differed in several key respects: 7(a) loans typically
were larger and more likely to have variable rates, longer maturities, and
higher interest rates.

SBA's most recent reestimates of the credit subsidy costs for 7(a) loans
made during fiscal years 1992 through 2004 indicate that, in general, the
long-term costs of these loans would be lower than initially estimated.
SBA makes its best initial estimate of the 7(a) program's credit subsidy
costs and revises the estimate annually as new information becomes
available. In fiscal years 2005 and 2006, SBA estimated that the credit
subsidy cost of the 7(a) program would be equal to zero--that is, the
program would no longer require annual appropriations of budget
authority--by, in part, adjusting fees paid by lenders. However, the most
recent reestimates, including those made since 2005, may change because of
the inherent uncertainties of forecasting subsidy costs and the influence
of economic conditions such as interest rates on several factors,
including loan defaults and prepayment rates.

References

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  10. http://www.gao.gov/
  11. http://www.gao.gov/fraudnet/fraudnet.htm
  12. mailto:[email protected]
  13. mailto:[email protected]
  14. mailto:[email protected]
  15. http://www.gao.gov/cgi-bin/getrpt?GAO-08-226T
  16. http://www.gao.gov/cgi-bin/getrpt?GAO-08-226T
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