By Bill Alpert

Changes that helped lenders hurt the U.S. Small Business Administration's flagship lending program and many of its borrowers.

Early defaults on loans backed by the SBA are on the rise. The defaults will haunt borrowers the rest of their credit lives. But the SBA loan program has been great business for a handful of lenders, thanks to the government's guarantees and the Biden administration's decision to eliminate the fees it charged for the government's backing.

A Senate hearing last week studied how the SBA's flagship loan program, known as 7(a), turned cash flow negative last year, after the agency dropped its fees and loosened its lending rules.

Leading the SBA's lending are three banks: the Columbus, Ohio-based superregional bank Huntington Bancshares; the Wilmington, N.C.-based Live Oak Bancshares; and the Boca Raton-based NewtekOne. Then there's Ready Capital, a money-losing New York real estate lender whose only profits come from high-rate loans made with the SBA's backing.

Delinquencies in the $116 billion SBA program have jumped to 2.5% from 1% in the last two years, according to a December SBA risk analysis seen by Barron's. Annual default rates have doubled to 3.2%, while loans defaulting in just their first 18 months have nearly tripled to almost 1.5%.

"This has harmed taxpayers and the small businesses saddled with debt they can't manage," Sen. Joni Ernst (R-Iowa) told the Wednesday hearing, "while the irresponsible lenders get paid no matter what."

A Barron's data analysis of the last five years worth of SBA records found a cross-section of business dreams that crumbled less than 18 months after their SBA loan approvals: truckers; beauty salons; a Flint, Mich., smoothie bar; a New Jersey carpenter; an Albany, Ore., hobby shop.

Since the 1950s, the SBA 7(a) program has guaranteed 50% to 90% of a lender's small business loan, in exchange for fees designed to make the program self-funding.

Interest rates began rising as the Federal Reserve fought inflation in 2022 and 2023. To sustain small business lending, the SBA eliminated its bank guarantee fees for most loans under $1 million, while loosening its lending rules.

Small businesses that entered the program found the variable rates on their SBA-backed loans climbing above 10%. The rate squeeze hasn't abated much since.

"That is a lot of money for a small businessperson. What may have penciled at 6%, often doesn't at 10%", says Ben Sabraw, managing director at Phoenix-based SMS Financial, which invests in distressed loans.

Even as the bad loans bought from banks by the SBA, under the guarantee, doubled in the agency's last two years -- to $1.6 billion -- lenders thrived.

With a government guarantee that costs nothing for many loans, the 7(a) program can be great for the lenders, says Eric Bowles, a retired banker who once ran SBA lending for BofA in Georgia. "They are lending money at prime plus 2 or 3%, and the guaranteed 75% of it is effectively a government security."

That guaranteed portion can be sold at a premium to investors in the secondary market.

The biggest SBA lender, Huntington Bancshares, made nearly $10 billion in 7(a) loans over the past five years. SBA data through December 2024 shows that Huntington's loans perform as well as the average bank in the program, with some 0.35% of the guaranteed amounts charged off.

Almost matching Huntington's 7(a) volume is Live Oak Bancshares. It grew SBA-backed lending from $1.8 billion in 2022 to $2.8 billion in 2024. Live Oak's default rates have been lower than other SBA lenders, but the bank told investors that they began rising near the end of the fourth quarter.

An uptick in defaults doesn't perturb everybody associated with small business lending. The SBA's mission, after all, is to spark economic growth and job creation.

"To grow the economy, we must have more businesses applying for and then getting SBA loans," says Dan Rogers, who worked at the SBA before joining the small business lending team at the First Bank of the Lake. "With that, Americans and U.S. politicians and the bank lenders all must be tolerant of some defaults."

The SBA's last public report under the Biden administration highlights the 777,000 jobs it says were preserved by its loan programs. Nowhere does it discuss the 7(a) program's fall into negative cash flow.

A substantial share of 7(a) loans are made by credit unions and nonbank financials firms. Credit unions had the lowest rate of 7(a) charge-offs of any class of lender in the last five years, with just 0.18% of the amount the SBA guaranteed.

Nonbank financial firms -- now some the program's biggest lenders -- had the highest charge-offs. These non-depositary institutions averaged 0.49% of their guaranteed amounts charged off since 2019.

NewtekOne made SBA-guaranteed loans for two decades as a business-development company. In 2023, it bought a small bank and does its SBA lending under the bank's license. NewTek originated $6.3 billion in 7(a) loans over the past five years.

Selling the government-guaranteed portion of loans has been a key strategy for Newtek. The "gain on sale" profit from these securitizations is seven times Newtek's interest income.

But many investors think that "gain on sale" profits aren't a durable business strategy, and NewTek's stock has sunk from $35 in 2021, to a recent $13.

NewTek didn't answer Barron's queries about its business. But the company has tried to reassure investors that it can reap gains on sale in all financial weather. "People don't like gain on sale, I can understand that," said chief executive Barry Sloane on a November 2024 call. "If gain on sale is an anomaly, because rates move up and down and spreads change, yeah. But this is our business."

When Newtek reported December quarter results last week, it compared the credit quality of its loan portfolio to Live Oak's. In 2024, the Newtek bank's net charge offs were almost 1.3% of its average loans; Live Oak's were under 0.5%.

Newtek's change to a bank left Ready Capital as the SBA program's largest non-depositary lender, with $3 billion in loans over five years. Organized as a real estate investment trust, ReadyCap still makes 60% of its loans for real estate. As Barron's has reported, ReadyCap's real estate borrowers have been struggling and the REIT has repeatedly cut its dividend. The stock fell 30% this week with the report of a big December quarter loss and another dividend cut.

That has made SBA loans crucial for Ready Capital. In 2024, the REIT's real estate lending had negative net interest income, after counting loan losses. But the company nearly doubled its SBA dollar lending, originating over $1 billion in loans. That generated the company's only interest income, as well as gains on selling the government-guaranteed portions of the SBA loans into the secondary market.

The interest rate that Ready Capital charged its small business borrowers was higher than most banks, averaging more than 11% in the five years of SBA data. By comparison, Huntington charged just above 8%, while Live Oak averaged 7.5%.

SBA data show that agency charge-offs on ReadyCap's loans have been lower than for other nonbank lenders. "We have lower overall defaults and lower early defaults than our large lender competitors," said a person close to ReadyCap.

The complexion of Ready Capital's SBA lending changed last year, however. From the SBA's September 2023 fiscal year to its September 2024 year, agency data show that ReadyCap ramped its 7(a) loan volume by more than 250%, while cutting its average loan size nearly in half. Those loans will have to season before its clear whether ReadyCap's credit quality has changed, too.

Problems in last year's SBA-backed loans won't start appearing until this year. That is because struggling business owners often throw in the towel at year-end, says distressed loan investor Sabraw. He expects a new wave of 7(a) charge offs soon.

"7a loans can behave like consumer loans," says Sabraw. "When they start to default, you may never get another payment."

Last week's Senate hearing signaled that the SBA loan program's negative cash flow will lead the agency's new administrators to end the practice of guaranteeing bank loans without a fee. Rising defaults may also spur the agency to return to sober lending rules.

If that happens, the growth of government-guaranteed lending profits may slow for lenders like Ready Capital.

Write to Bill Alpert at william.alpert@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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March 06, 2025 02:00 ET (07:00 GMT)

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