One reason small business lending is down is that many loans are secured by personal assets that have lost value. A recent article in the San Francisco Fed’s Community Investments journal explains what’s happening (PDF here). Author John Moon writes:
…some bank lenders had reported reducing the amount of their extended lines of credit as a result of lowered appraisal values on personal homes that secured these small business loans. For other businesses that borrowed directly through a home equity line of credit, notably immigrant micro-businesses, a similar reduction in credit resulted as home values were reassessed.
One study cited in the article, though dated, estimates that 55% of all small business credit dollars are personally guaranteed. So plummeting personal wealth — in the form of home prices, stock valuations, and other personal assets — make borrowers riskier to banks. The change is beyond the business owner’s control. It has nothing to do with how well the business is run, demand for its products or services, or the owner’s ability to manage cash flow and make timely payments. But it still affects the supply of credit.
The personal guarantees also affect the demand for credit, Moon notes. Entrepreneurs who have already seen their wealth evaporate are unlikely to gamble what remains of their home equity in an uncertain business environment.
This dynamic isn’t limited to personal assets. The falling value of commercial real estate, equipment, and other collateral for commercial loans has crimped credit for small and midsized firms. One solution being floated is collateral deposits, where a government or public-private partnership makes up for the shortfall in collateral by putting cash on deposit with the lender.
But there’s no easy fix. Moon writes:
The relationship between personal assets and small business financing has presented particular challenges during this economic downturn. On one hand, the pledging of personal commitments can help banks mitigate against greater risk associated with the economic downturn. On the other hand, the drop in asset values as a result of the recession makes it more difficult for small business owners to pledge personal commitments. The net result may be that on the supply side, access to credit is further constrained for small businesses because of this dynamic. On the demand side, a small business owner will be reluctant to pledge his own assets or provide a personal guarantee if he has a pessimistic outlook for his business or the economy. Fundamentally and not surprisingly, to increase credit supply and demand, asset values and business prospects need to improve.