1. Availability of Credit to Small Businesses and the Financial Crisis of 2008-???? Rebel A. Cole DePaul University

2. Overview Small business financing Small business financing Small-business credit allocation process Small-business credit allocation process Impact of financial crisis on availability of credit to small firms Impact of financial crisis on availability of credit to small firms BankingBanking Real Estate: Commercial and ResidentialReal Estate: Commercial and Residential Regulatory BacklashRegulatory Backlash Appraiser BacklashAppraiser Backlash UnemploymentUnemployment

3. Small Business Financing in U.S. Most small businesses rely upon banks for debt financing. Most small businesses rely upon banks for debt financing. Small businesses typically use real estate as collateral for loans. Small businesses typically use real estate as collateral for loans. Most small businesses also use personal and business credit cards for debt financing. Most small businesses also use personal and business credit cards for debt financing.

4. Small-Business Credit Allocation Process: Three Steps (1) Need Credit? (2) Apply for Credit? (3) Get Credit? No Yes No Non-Borrower Discouraged Borrower Unsuccessful Borrower Successful Borrower Source: “Who needs credit and who gets credit?” Cole (2008)

5. Credit-Allocation Outcomes Source: “Who needs credit and who gets credit?” Cole (2008) Data from Fed’s SSBF

6. Banks Lending has fallen at 19% annual rate during past three months. Lending has fallen at 19% annual rate during past three months. Business lending has fallen at 28% rate. Business lending has fallen at 28% rate. Why? Why? Banking system is in serious trouble that continues to worsen. Banking system is in serious trouble that continues to worsen.

7. Banks Failures pass 100 for first year since 1992. Failures pass 100 for first year since 1992. More than 400 “problem” banks. More than 400 “problem” banks.

8. Banks Asset quality continues to deteriorate. Asset quality continues to deteriorate. NPLs rose from 2.95% to 3.76% in Q2 2009, to highest level since 1991.NPLs rose from 2.95% to 3.76% in Q2 2009, to highest level since 1991. Based on asset quality, several thousand are constrained in ability to make new loans.Based on asset quality, several thousand are constrained in ability to make new loans. Industry holds $700 billion in HELOCs. Industry holds $700 billion in HELOCs. Big Four (JPM, BofA, Citi, WFC): $420 billionBig Four (JPM, BofA, Citi, WFC): $420 billion Industry holds $1.6 trillion in Commercial Real Estate loans, of which almost $600 billion are Construction & Development. Industry holds $1.6 trillion in Commercial Real Estate loans, of which almost $600 billion are Construction & Development.

9. Real Estate Most small businesses pledge real estate (personal and/or business) as collateral when applying for credit. Most small businesses pledge real estate (personal and/or business) as collateral when applying for credit. During the crisis, residential real estate values have fallen precipitously. During the crisis, residential real estate values have fallen precipitously. Currently, commercial real estate values are following suit. Currently, commercial real estate values are following suit.

10. Residential Real Estate Values have dropped from 2007 highs to 2002- 2003 levels: Values have dropped from 2007 highs to 2002- 2003 levels: Depending upon locale, this means value has fallen 20% to 50%.Depending upon locale, this means value has fallen 20% to 50%. Both delinquency and foreclosure rates continue to hit new all-time highs month after month (source: LPS). Both delinquency and foreclosure rates continue to hit new all-time highs month after month (source: LPS). Sep.: combined 12.49% (9.37% Del. / 3.12% Forc.)Sep.: combined 12.49% (9.37% Del. / 3.12% Forc.) Aug.: combined 12.20% (9.06% Del. / 3.04% Forc.)Aug.: combined 12.20% (9.06% Del. / 3.04% Forc.) More than 600,000 NEW delinquencies each month.More than 600,000 NEW delinquencies each month. Compare with 500,000 TOTAL trial modifications.Compare with 500,000 TOTAL trial modifications.

11. Option-ARM Tsunami is Coming

12. Commercial Real Estate Continuing and serious deterioration. Continuing and serious deterioration. “Cap rates” fell as low as 4% at market peak in 2007, but now have skyrocketed to 8% and higher. “Cap rates” fell as low as 4% at market peak in 2007, but now have skyrocketed to 8% and higher. “Cap rate” is essentially a discount rate for valuing real estate income as a perpetuity.“Cap rate” is essentially a discount rate for valuing real estate income as a perpetuity. This means that CRE property values have fallen by as much as 50% or more.This means that CRE property values have fallen by as much as 50% or more.

13. Credit Cards Banks are aggressively cutting back on credit lines, especially credit cards. Banks are aggressively cutting back on credit lines, especially credit cards. Credit-card losses are at all-time highs.Credit-card losses are at all-time highs. Estimate are that credit-card credit lines have been cut by 25% and more during the crisis. Down $400B in 2009 Q2 alone.Estimate are that credit-card credit lines have been cut by 25% and more during the crisis. Down $400B in 2009 Q2 alone. Many unused credit lines have been cancelled.Many unused credit lines have been cancelled. SSBFs: Most small businesses use credit cards to finance their firms.SSBFs: Most small businesses use credit cards to finance their firms. This is seriously impacting the availability of credit to these firms.This is seriously impacting the availability of credit to these firms.

14. Regulatory Backlash Bank examiners have tightened standards. Bank examiners have tightened standards. Yesterday’s performing loans are today’s non-performing loans.Yesterday’s performing loans are today’s non-performing loans. “performing non-performing” loans have returned, but now because collateral values have fallen, even if cash flow is sufficient to cover debt service.“performing non-performing” loans have returned, but now because collateral values have fallen, even if cash flow is sufficient to cover debt service. More NPLs => More required capital=> less lending.More NPLs => More required capital=> less lending. Banks have responded to the whip by tightening underwriting standards. Banks have responded to the whip by tightening underwriting standards. Higher standards => less lendingHigher standards => less lending

15. Appraiser Backlash Real estate appraisers strongly criticized for role in mortgage meltdown. Real estate appraisers strongly criticized for role in mortgage meltdown. MAI = “made as instructed.”MAI = “made as instructed.” Now much less generous in valuations.Now much less generous in valuations. Many inappropriately use distressed sales as comparables, pushing values down.Many inappropriately use distressed sales as comparables, pushing values down. Huge problem for owners of CRE properties Huge problem for owners of CRE properties Typically use short-term financing.Typically use short-term financing. Need to refinance, but cannot because properties appraise at less than original loan amount.Need to refinance, but cannot because properties appraise at less than original loan amount. Bring new money to the table or default.Bring new money to the table or default.

16. Unemployment Disproportionately falling on small businesses, including the self-employed. Disproportionately falling on small businesses, including the self-employed. Currently 9.8% (10.3% for men) HH Survey: 785,000 jobs lost in Sep.HH Survey: 785,000 jobs lost in Sep. Estab. Survey: 293,000 jobs lost in Sep.Estab. Survey: 293,000 jobs lost in Sep. Next Friday: Oct. employment situation Next Friday: Oct. employment situation Expect unemployment to rise to 10.0%+Expect unemployment to rise to 10.0%+ Likely to stay above 10.0% through 2010.Likely to stay above 10.0% through 2010. More job losses=>More RE delinquencies. More job losses=>More RE delinquencies.

17. Summary Small businesses are critical to the U.S. economy. Small businesses are critical to the U.S. economy. Bank loans are critical to health of small businesses. Bank loans are critical to health of small businesses. Banking system remains in dire straits, largely because of residential and commercial real estate markets, which continue to deteriorate. Banking system remains in dire straits, largely because of residential and commercial real estate markets, which continue to deteriorate. Rising unemployment leads to continuing deterioration in real estate markets. Rising unemployment leads to continuing deterioration in real estate markets.

18. Summary In what shape is the economy going forward into 2010 and beyond? In what shape is the economy going forward into 2010 and beyond? V ?V ? L ?L ? W ?W ? U ?U ?