ARC Loans' Weak First Month

Diego Iorio sounds like the kind of small business owner the government's new ARC loans are made for. His two-employee audio gear retailer, SIRS Electronics, had been profitable through last year, with 2008 revenue nearing $500,000, but his projections for this year are down 40% to 50%. Although he has not missed any payments yet, SIRS, based in McAllen, Tex., has $140,000 in debt split among credit cards and payments owed to vendors. "We are in a very delicate situation right now," the 41-year-old Iorio says.

He prepared 200 pages of paperwork, including financial statements and tax returns going back three years, and applied for an ARC loan through Wells Fargo (WFC) just after the program launched June 15. The loans, made by banks and fully guaranteed by the government, give small businesses up to $35,000 interest-free to pay off other debts for up to six months, with repayment deferred for a year after that. But Wells Fargo rejected Iorio's loan application because his personal credit score, at 649, was below the 680 the bank requires. To Iorio, it's a catch-22: His score had been above 700, but it suffered when he took on debt to support the business.

The Small Business Administration's ARC loan program, funded through $255 million from the stimulus package passed in February, is intended to buoy viable small businesses that face "immediate financial hardship," not to prop up zombie companies. But a month into the program, ARC looks like weak medicine for ailing firms like Iorio's.

Projected Default Rate Scares Lenders It's early days, to be sure, but even ARC's stated goals are meager. The program aims to guarantee 11,000 loans worth $340 million through 2010, saving some 55,000 jobs. By contrast, loans made through the SBA's main 7(a) guarantee program have declined by $2.3 billion in the first half of 2009, a drop of more than one-third from the same period last year.

In the first four weeks of the program, ARC funded $12 million in 371 loans through 178 lenders. But some business owners are unclear about which banks are participating. The SBA is not tracking it centrally, though local offices may be able to refer borrowers. Some of the biggest lenders such as Citi (C) are not participating, and others, including Bank of America (BAC), haven't decided yet. [Update: While a Citi spokesperson originally told BusinessWeek Citi is not participating in the ARC loan program, after this story was published she said the bank is evaluating the program.] Many are lukewarm on the plan because defaults are expected to be high: The Office of Management & Budget has projected a staggering 56% default rate on ARC loans. "This is a different and riskier program than traditional SBA loan programs, designed to meet the unique challenges the recession has placed on small businesses," OMB spokesman Ken Baer says in a statement.

Even though the SBA guarantees every penny, such a high default rate scares away lenders because it can be costly to collect, says Tony Wilkinson, president of the National Association of Government Guaranteed Lenders, a trade association of 650 SBA lenders. Banks earn interest of 2% above prime (the prime rate is currently 3.25%), paid by the SBA—borrowers pay no interest. That's a relatively small return for loans with a high default rate.

But the SBA hopes the pace will pick up. "You have to give these banks time," says Karen Gordon Mills, who was confirmed as the new SBA chief in April. "This is different and we had to be very clear about what a viable small business was," meaning companies that were profitable within the past two years and have a plan to return to profitability. Mills also says that other SBA lending has increased 40% since the agency cut fees and expanded guarantees in the 7(a) program to 90% as part of the stimulus package.

More Aid for Small Business? Still, given the tepid response from lenders and borrowers, there's some speculation that the SBA might plan further aid for small businesses. A Washington Post story last week suggested a plan was in the works to funnel money from last year's $700 billion bank bailout to small firms through SBA loans. Mills wouldn't comment directly on the idea but said there were ongoing discussions in the Obama Administration about how to help small companies create jobs.

Business owners would welcome more robust aid from the government, especially since other credit sources have disappeared. Doris McMillon is seeking an ARC loan for her three-employee communications consulting firm in Fort Washington, Md., since she has had tens of thousands of dollars in credit lines and cards cut. She would like to bring on another person, but she doesn't have the cash flow to support it. "Things are just very tight," says McMillon, who has been in business for 23 years. "I'm looking at the ARC loan as one of the vehicles that will help me reduce the debt and give me some breathing room."

Iorio does not know what to do next since his application for an ARC loan was denied. "We are not delinquent in any account yet, but we don't want to be," he says. "Honestly we're just praying, and trying to keep our eyes open to see where we can find some relief to the situation."

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