Managing Problem Loans Under U.S. Small Business Administration 7 Guarantees

RMA Journal, The, Feb, 2001 by Thomas Wallace

At each step of the way in SBA lending, and especially when a loan payment approaches 60 days past due, financial institutions must be able to provide satisfactory answers to three broad questions to ensure the SBA guarantee. This article presents those questions as well as an overview of the liquidation process for SBA loans.

Given the length of the economic expansion an d what must happen to "all good things," prudence dictates that lenders consider the risks inherent in uncertain times. For several reasons, loans supported by the guarantees of the federal government through the Small Business Administration (SBA) 7(a) program may merit this consideration more immediately.

The 7(a) program fills a legitimate role in lending by supporting extensions of credit to worthy borrowers whose situations may not meet with the letter of credit policy. Recent legislation provides even more support for these loans, by offering a guarantee, under certain stipulations to the lender, generally of 75% up to $1 million. By regulatory definition and practical implementation, 7(a) loans tend to have exposures for term working capital under limited financial covenants and without extensive call provisions. Given the relative liberality of these credit extensions, it would seem anecdotally valid to consider that, in a downturn or slowdown of the overall economy, these credits are likely to suffer first and possibly the most.

Preserve the Guarantee

The primary goal in managing a problem 7(a) loan is to preserve the guarantee. The presence of the guarantee was critical in the loan's approval and is even more so if liquidation is a possibility. (As a point of terminology, the SBA refers to all loans not performing as agreed as "liquidations," thus making no distinction between workout and the typical banking usage of the word.)

The accounting for the SBA's guarantee is much like that of a participated loan, although the SBA's participation is generally at a critical stage in the loan's trajectory. After the claim under the guarantee, the SBA participates in 75% of the activity--including jointly agreed-upon recovery costs and up to 120 days of interest, with limits--while awaiting the SBA's guarantee participation. The rough accounting of a liquidation scenario with and without the presence of a guarantee can be seen as follows:

Loan amount outstanding $400,000

SBA guarantee 75%

Net liquidation value of collateral, etc. $200,000

Uncollected chargeoff, remaining after guarantee claim $50,000

Remaining without guarantee $200,000

In a situation where one outcome is the quadrupling of the exposure in a transaction, all actions should be very carefully considered.

Decisions Regarding Guarantee Liability

While the decision to not honor a guarantee is necessarily subjective, the SBA seeks answers to three broad questions:

1. Was the loan closed in accordance with the SBA authorization letter, as appropriately amended?

2. Were the monitoring and credit management requirements of the authorization complied with?

3. Did the lender act with normal prudence for the industry and comply with the rules and regulations of the SBA in managing the liquidation?

The third question potentially represents a considerable tightening of the SBA's posture on honoring guarantees to lenders. Previously, so long as there were no costs or increases in the SBA's liability as a result of these failures, the SBA was willing to fully honor a lender guarantee even if a lender had failed to act prudently or to comply with SBA requirements. The SBAs stance is now evolving toward the position that such failures can result in either an outright "denial of liability" (SBA terminology for refusing to honor the guarantee) or a "repair," depending on degree. ("Repair" is the SBA terminology for a reduction in the guarantee percentage and thus eventual participation.) At this writing, this is a profoundly subjective decision in a gray area and is being further defined by SBA. A lending institution's proactive management of the credit extension can greatly influence how it fares under these three tests.

1. Was the loan closed in accordance with the SBA authorization letter, as appropriately amended? The ultimate demonstration of proactive management is to execute the process correctly in the first place. In any SBA loan file there should be a closing file checklist to verify the existence and location of documentation critical to the credit extension. If the checklist is modified to include a column that cross-references the item to the SBA authorization letter, this question can be definitively answered. [1] Effective documentation of the closing should be regarded as the fundamental basis of proactive management.

2. Were the monitoring and credit management requirements of the authorization complied with? In this case, proactive management extends back to the issuance of the authorization and thus the credit approval decision. When approving a SBA loan, a certain level of risk tolerance is called for; therefore, allowances should be made for the credit standards imposed. The likelihood of strict borrower compliance with detailed covenants is at best limited in the less sophisticated realm of typical SBA borrowers. However, the problem becomes more than one of merely dealing with issues of ongoing technical defaults. Failure to adequately monitor a loan's covenant compliance can lead to the conclusion that the lender did not act prudently and thus can lead to repairs or worse. To the extent that there are technical covenants, and the SBA prefers that there not be, they should be straightforward and mainly informational in nature. The corollary to this is that immediate portfolio management tools, such as overdraft and immediate past due reports, should be aggressively managed.