In Stephen M.R. Covey’s wonderful book, The Speed of Trust, he asserts that when trust levels are high among participants in any transaction, speed is enhanced and costs are reduced.  Covey shares a story of Warren Buffet agreeing to a $1.1 billion acquisition of a Wal-Mart subsidiary in one meeting, just because he trusted Wal-Mart management that much.  It was one of my favorite vignettes in the book.  Truly legendary.  And, from a PPP perspective, instructional.

We are three days into the PPP race to deploy $350 billion to U.S. small businesses, and still sputtering.  The forward movement will come from banks.  A number of banks have opted not to participate, while others have implemented their own credit policies to narrow the focus.  What bank wouldn’t want to be taking that glorious victory lap, slapping five all around the winner’s circle?  Seems like the perfect PR photo op.  Why the reticence?  No easy answers, but some of the dynamics in the program are useful to understand.  And, I do believe we will have strong momentum soon.  Here is a list of where the top 100 SBA lenders stand in their adoption of PPP as of April 7.

In my first blog in this series on PPP and tensions between the SBA and banks, I referred to the five Cs of credit – the natural laws of lending.  Before I get to the C’s, let’s hit the Golden Rule: always have two sources of repayment, three if you can get it, and never have collateral as your primary source.  Embedded in that are three big C’s – (C) apacity (cash flow/income) to service the debt must stand on its own.  (C) ollateral and (C) haracter in the form personal guaranties are simply ways to wriggle out the back door of the bar unharmed after the fight has started.

The SBA’s 7(a) lending program brings two key enhancements to Small Business lenders. First, the extended terms offered under the program (25 years for real estate and 7-10 years for working capital and equipment) reduce fixed debt service obligations, which effectively increases the capacity to service debt.  If I had $5 of cash flow to service debt, and $5 of debt service, my debt service coverage ratio would be 1:1.  Banks do not like to play it that close, usually underwriting to something in excess of 1.25:1.  Excess capacity.  Now, if SBA extended terms reduced my debt service from $5 to $3, debt service coverage improves from 1:1 to 1.66:1.  That’s just a safer bet, isn’t it?

The other enhancement is that, in the unfortunate event of a credit default, the lender has the SBA lined up to share in losses with them.  The SBA takes 75% of the loss after all secondary and tertiary repayment sources are exhausted, and the lender takes 25%.  That’s another very attractive enhancement, but predicated on the fact that the lender was in perfect accordance with the SBA’s 400 page SOP every step along the way – underwriting, closing, documenting, servicing, collecting.  Proven missteps can reduce the extent to which the SBA will share in losses (“repairs”).  In the most egregious cases, the SBA will walk away altogether (“denials”).  Repairs and denials keep SBA lenders up at night.  I will let your imagination wander as to how many vagaries and inconsistencies may exist in a 400 page SOP.

Let’s just consider how PPP is different from the traditional 7(a) program.  The traditional underwriting model is moot.  Many of the eligible borrowers have ceased operations, and no one knows what the economic climate will be over the next 12-24 months.  Very difficult to lend on capacity.  The primary repayment source is debt forgiveness promised by the SBA for meeting employment guidelines between now and June 30.  That means that not only do the lenders need to do everything that THEY are supposed to do, every borrower must re-hire to pre-pandemic levels and the loan proceeds have to be used in accordance with PPP’s stated purpose.  Keep in mind that money is fungible – it can flow anywhere in the income statement or balance sheet, so the banks need to be diligent about monitoring that in addition to remaining in compliance with all other SOP requirements, and on a scale previously never seen by SBA.

Now consider this….you are an approved SBA lender and you know abiding by the rules is going to make or break you.  The day of program launch, you still do not know what the rules are.  Just one example: as originally proposed, PPP offered 10 year repayment terms to borrowers who did not qualify for debt forgiveness on the back end.  On the eve of rollout, that was changed to 2 years.  What else is not as originally pitched?  You still do not have the special-purpose PPP application form.  Borrowers have eclipsed “eager and ready” into “desperate”. And, not only are the rules unclear, you are preparing to play the game on a scale on which you have never played: probably ten years’ worth of applications in a week.  Not exaggerating.

I have no doubt that on a simply altruistic level of compassion and concern, banks want their clients to survive, and thrive.  They want to be on that victory lap.  From a sober-eyed credit risk standpoint, credit managers also understand that PPP is the most likely way to mitigate epic levels of credit losses in their Small Business portfolios.  But when you are unable to fully understand program rules and processes, you may unwittingly increase your losses by participating.

Right now, PPP reminds me of a parent coaxing a child to jump in the pool for the first time.  “Come on….I’ve got you!”  The child bends down and looks at the water real close, then stands back up again.  And again.  In time, we will get the critical mass behind this effort to make it successful.  The question is how long, and how much liquidity do these businesses have to make it until then?

NEXT TIME:  The incremental costs of being an SBA lender