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Disaster loan reform waiting to happen.

The Small Business Administration's Disaster Assistance loans are, collectively, the federal government's primary disaster-relief program. The government-financed loans help not just small businesses, but also individuals, businesses of all sizes, and nonprofits to reestablish after a disaster. Unfortunately, the program's performance has been mediocre, to say the least. Congress is now considering possible reforms, however they are modest in scope and the program will likely continue to underperform for disaster victims.

AIDING CITIES, NOT PEOPLE Congress authorizes the SBA to provide low-interest loans to disaster victims contingent upon a disaster declaration from the president or the SBA administrator, and a demonstrable ability for the recipients to repay the loans. The loans can be used to repair or replace real estate (up to $200,000) and personal property (up to $40,000), as well as to reestablish businesses and nonprofit organizations regardless of size (up to $1.5 million). Loans can be for a period of up to 30 years. The SBA has more relaxed underwriting standards than private-sector lenders, which allow it to lend money to riskier borrowers.

What restrictions should be placed on the loaned funds? Private insurers provide clients with checks after the destruction of an insured asset like a house or car, and it is left to the recipient to decide whether to purchase another car or house, or do something else with the money. In contrast, public disaster assistance mandates that the loan be used to rebuild in the same location. For example, in the wake of the devastating 2005 Gulf Coast hurricanes Katrina and Rita, policymakers momentarily considered dispensing financial aid directly to victims, to be used at their discretion. However, the possibility that many recipients would use the money to move out of the long-impoverished and hurricane-prone area resulted in the idea's quick abandonment. The federal government's relief effort was instead geared toward rebuilding New Orleans and encouraging its residents to stay.


Because politicians gain reelection from specific places, they oppose disaster-relief policies that allow geographic mobility. They want individuals to stay and rebuild in the same area, and feel gratitude to their local representatives. The result is inefficient location decisions, for two reasons: First, residents and businesses do not pay the full cost of their location decisions, as the loans have no risk premiums. And second, the assistance ties people to locations that typically are prone to disaster rather than allowing them to move to safer areas.

DECLINE, WITHDRAW, AND CANCEL In July of 2007, the Senate Small Business Committee held a hearing to evaluate the SBA's efforts in the wake of the 2005 Gulf hurricanes. It found that the SBA was not delivering disaster loans. Two years after Katrina destroyed New Orleans and devastated the region, the SBA still faced a huge backlog of loans, revealing its inability to process applications in a timely matter. And the SBA's loan-approval rate dropped from an average of 60 percent for previous hurricanes--including destructive Andrew in 1992--to 33 percent.

Even among approved loans, the SBA failed to disburse the funds. Of the nearly 423,000 applications submitted, some 160,000 were approved, and yet two years after Katrina, the SBA had only fully funded 22 percent of the approved loans. According to the SBA's inspector general, at the end of 2006, the SBA had accumulated a backlog of more than 90,000 undisbursed loans.

Faced with growing criticism, the SBA launched a "90-in-45" campaign meant to expedite disbursement of $6 billion in allocated funds to resolve the 90,000-loan backlog within 45 days. SBA loan officer Gale Martin testified to the Senate committee, "I have brought with me the written testimony of eight other loan officers. We join together and we all agree that we were being forced by management to cancel, decline, and withdraw applications unnecessarily and unjustly in order to make the numbers look good to the public, the press, and Congress." Martin explained that it takes almost no time to take such actions, and they could cite all sorts of justifications for doing so, especially after the SBA changed the criteria for declining or canceling a loan. So SBA loan officers under deadline did just that: they began to decline, withdraw, and cancel loans.

According to a report by the SBA inspector general, as of January 25, 2008, the SBA had withdrawn 68,456 loan applications, many of them inappropriately. The report notes, "We believe the lack of contact with applicants and hasty withdrawals occurred due to production goals, set forth in a directive issued by the Director of Disaster Loan Processing. In order to meet these goals, loan officers told us they were aware that some officers would withdraw incomplete applications as doing so was easier than getting them approved."

At the end of her testimony, Martin said, "I could go on, and on, for hours here, but the truth is that only the wealthy moved through the system easily. People with credit issues, who owed the government even a little bit of money, who had lost their documents, or who just moved around, would probably not be given a loan, and if they were, they would have to fight to keep it."

RECENT REFORMS During the July 2007 Senate committee hearing, the Government Accountability Office released a report that questioned whether the SBA was prepared to handle another Katrina. Congress must not think so because it included a major overhaul of the SBA's disaster loan program in last year's farm bill.

The new legislation allows private-sector lenders to make short-term "bridge loans" to businesses damaged by disasters. Businesses could use bridge loans while they await processing of their regular SBA disaster loans or insurance payments. In the event of a catastrophic disaster, lenders as well as the SBA could make disaster loans. All lenders could make disaster loans to small businesses, and preferred lenders in the SBA's 7(a) business loan program could make disaster loans to individuals.

The bill also authorizes the SBA to pay lenders to process disaster loans when applications overwhelm the agency, as was the case in 2005. The bill makes businesses anywhere in the United States eligible for disaster loans if they suffer economic injury as a direct result of the disaster, a measure similar to one enacted by Congress following the September 11, 2001 terrorist attacks. Finally, the legislation increases the maximum amount of a disaster loan from $1.5 million to $2 million and requires the SBA to create disaster response plans for various scenarios and conduct disaster simulation exercises every other year.

While the bill provides some improvements over the current system--such as stopping disaster victims from receiving payments from multiple agencies--it also contains serious flaws. First, the bill authorizes billions of dollars for use during a disaster, but the cost is not offset elsewhere in the budget. Supporters claim that most of the bill's costs cannot be offset because no one can plan on spending disaster-related funds. But the truth is that the only obstacle to offsetting the cost of disasters is Congress. Congress chooses not to financially plan for disasters as part of its budget process. It might not know precisely when or where the next disaster will occur, but it knows that disasters will occur. Hence, Congress could and should carve out a disaster fund from the budget on the assumption that it will have to spend money on future disasters.

Second, supporters of the bill claim that the government should provide services to any and all businesses that are "adversely affected." The problem with such language is that it places no easily defined limits on eligibility, in part because the policy is based on thinking of disaster relief as stimulus. And who could oppose more stimulus? To be sure, the money comes from taxpayers and reduces their welfare, but that loss isn't discussed.

Third, Congress models the revised disaster loan program on the Supplemental Terrorist Activity Relief Program (STAR)--a program that is hardly an example of sound government response to disaster. Enacted following the 2001 terrorist attacks, STAR was supposed to provide federal loans to businesses around the country that were affected by the attacks. A 2005 report by the SBA's inspector general showed that both lenders and loan recipients abused STAR. Testifying the following spring before the Committee on Homeland Security Subcommittee on Management, Integration, and Oversight, the inspector general reported, "Most lender files did not contain sufficient information to demonstrate that borrowers were adversely affected by the September 11th terrorist attacks and their aftermath. As a result, eligibility could not be determined for 85 percent of STAR loans reviewed."

As it turned out, lenders wrongfully advertised the loans to customers as an opportunity to receive lower interest rates rather than as a loan program intended for 9/11 victims. According to the inspector general's report, many recipients had no idea they were receiving 9/11 loans rather than regular SBA loans. For instance, in 2002, Nevada Construction Cleanup, which removes debris that subcontractors leave at job sites, received a $1.53 million STAR loan to expand its business. David Marino, the company's controller, told the Las Vegas Review Journal that he has no idea how Nevada Construction Cleanup landed on the list of terrorism-relief loan recipients. "This loan was way before 9/11," he explained. Marino was unable to pinpoint a precise borrowing date, but he said his firm had had its SBA loan for at least 4? years. Terrorism recovery "wasn't even a thought in anybody's mind at that time," he added.

According to the Journal, officials with the various banks that handled the loans told investigators that they only qualified businesses for the anti-terror loans after SBA officials aggressively marketed the program to "mean that every small business could claim it was somehow impacted by the attacks, and therefore, eligible to receive a STAR loan." The inspector general's report supports this statement and blames top agency officials for the way the SBA promoted the program "by advising lenders that virtually any small business qualified and assuring them that SBA would not second guess their justifications."

The report cites other abuses of the program. A Texas golf course owner received a $480,000 STAR loan under the justification that "people were more interested in staying home and watching the attack on television than playing golf." That the course had a different owner when the attacks took place and the justification for loan guarantees did not apply to the new owner did not prevent the lender from disbursing the loan. A Las Vegas tanning salon received a $583,500 loan on December 3, 2002. A company representative told investigators the business was not harmed by the terrorist attacks, but investigators ignored the statement because "many of the customers who use tanning salons are performers in casinos and work in various capacities in the casino industry," and "Las Vegas tourism was hit hard by 9/11, and many casino workers lost their jobs or had their hours scaled back.... This is a large part of(the borrower's) customer base." Better yet, according to the same report, "the lender's credit memorandum showed the borrower experienced a 51.6 percent sales growth for 2001 and an annualized 2002 sales growth of 31.6 percent." In the end, STAR became just another way for lenders to make money by leveraging a government guarantee. It did not serve the people it was intended to help. It is easy to see how the reformed SBA disaster loan program could suffer the same failing.

The fourth major problem with the proposed SBA disaster loan reform legislation is that it does not lay down solid rules for what constitutes a disaster. This lack of clarity opens the door for massive increased federal intervention on behalf of businesses that are affected by "disaster" conditions as different as snowfall or rising fuel prices, just to name two examples.

Finally, the bill encourages private-sector lenders to make short-term "bridge loans" to businesses damaged by disasters, which has the potential to become corporate welfare for banks and lenders. The new program would rely heavily on the SBA's main small business lending program, the 7(a) program. The program authorizes selected banks and preferred lenders to make loans to small businesses that cannot receive credit elsewhere. The government guarantees up to 85 percent of the loans, greatly reducing the risk to lenders. Similarly, under the new lending program, the government would guarantee up to 85 percent of any loans that private banks would make to victims of a disaster.

Bank of America is the single largest SBA loan provider in the country, with J.P. Morgan and Wells Fargo not far behind. David Bartram, president of the National Association of Government Guaranteed Lenders (an association of banks that make SBA loans), said in a 2006 hearing on the SBA, lenders "can be as profitable in a 7(a) loan program as we are in our conventional lending if done correctly."

The provisions in the farm bill open the disaster loan program to private lenders in a similar fashion. Not surprisingly, the lending industry supports the program: they are likely to gain from it financially. But if lenders are not scrupulous in how they make disaster loans, this program could cost taxpayers dearly. Some 16-18 percent of all regular 7(a) small business loans default, and disaster bridge loans could have an even higher default rate. "An unpublished Small Business Administration report estimates that up to a quarter of Louisianans who took out SBA loans after Katrina may default on them within the next two years," reports Reason's Dan Rothschild. As of 2007, guarantees on SBA loans represented some $83 billion in potential taxpayer liabilities. Irresponsible lending practices increase the probability that taxpayers will pay the bills and the federal government will own many disaster victims' homes and businesses.

CONCLUSION Disaster relief emphasizes the welfare of places rather than people because politicians represent people in specific places. Congress has never been willing to approve policies that resemble private insurance and give individuals cash after disasters. Current evidence suggests that disaster loans are best described as corporate welfare for the banks that disburse them and the clients that receive them. Those really in need receive little assistance. And recent reforms are unlikely to alter those results.


Mercatus Center

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University and an adjunct scholar of the Cato Institute.
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Title Annotation:BRIEFLY NOTED
Author:de Rugy, Veronique
Date:Mar 22, 2009
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