The 504 Loan Program Continues to Tread Water

By Charles H. Green

The good news: 504 lending grew in FY 2015! The bad news: the program’s 2.35% rate of growth was less than the overall U.S. economy last year (2.4%), in addition to being lower than GDP growth in other booming economies such as Vietnam (6%), Uzbekistan (8%) and South Sudan (36%, no joke). Check out the 504 program numbers broken down along with some statistical graphics in SBFI’s Capital View pages at 504 Loan Approval Analysis.

This uptick at least ended a two-year slide for the 504 loan program, which came on the 504heels following a banner FY 2012, when the program was allowed to refinance CRE loans for the first time ever and during the brief life of the First Mortgage Loan Program (FMLP). But the $4.29 billion of debentures (estimated $9.67 billion of total project costs) is still lower than every year–other than FY 2014 and the disastrous 2009–since 2005.

Other metrics for 504 lending this past year included the fact that there were only 5,787 debentures approved, which was 1.6% fewer than FY 2014, and continuing a numerical slide that has fallen almost 40% since 9,471 debentures were approved in FY 2012. The program still grew in dollar volume due to the fact that the average debenture grew to $742,688 this year, which so far as I can tell, is the largest ever, and nearly 5% higher than FY 2012.

Where is the loan growth?

The 504 program story is getting to be an old one and one surely to be dissected at length next week as the National Association of Development Companies (NADCO) gathers in New Orleans for their annual meeting. With multiple changes occurring in business finance, the commercial real estate industry, and Washington politics, they’ll have their hands full of more than beignets and Hurricanes.

During the financial crisis, 504 program usage fell off quickly, much like commercial real estate market sales. After four consecutive years (FY 2005-2008) leading up to the crisis, the program was thriving, averaging $5.59 billion in approved debentures. But the program went into a tailspin in FY 2009, falling to $3.8 billion (as did the 7(a) program, which went down to $7.8 billion) . Loan volume modestly bumped up the following year to $4.4 billion (+16%), but the 7(a) program did better, getting back to $10.9 billion (+40%).

Early in 2009, the Obama administration was in a scramble, sorting out dozens of new initiatives designed to stimulate the economy and recover from the worst economic event since the Great Depression. SBA was a familiar vehicle ready to do its share for the small business sector.

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But then there was a noticeable stumble. In the Fall of 2009, SBA rolled out stimulus terms for the 7(a) program that included a 90% loan guarantee for lenders and a $0 guarantee fee for borrowers. What’s not to love for all parties concerned, and  the program’s volume soared 65% up to over $18 billion in one year.

And the 504 program? For the first time in its existence, Congress authorized 504 debentures to be used to refinance CRE loans that were SBA-eligible, and simultaneously, to launch the FMLP so to reinvigorate the 504 first mortgage secondary market that had all but disappeared.

But much like a drunken sailor who missed the Normandy invasion because he was locked up in the brig, the 504 program spent many month waiting. SBA’s unbearably slow rule promulgation delayed the refinance program launch and left the 504 program listing in home waters.

The agency’s delays did not incite Congress to extend the refinance privilege terms beyond expiration to the vocal chagrin of the industry. Predictably, when the universally popular 504 refinance privileges ended on September 30, 2012, the program approval volume fell off immediately.

The FY 2013 results were couched with the expectation that the loss of 504 refinance authority was a temporary setback, because there was “bipartisan” support to reinstate it. But they did expire, and while it’s hard to find anyone leading the opposition to reinstatement or a single politician vocally against them, renewal and extension has languished for more than three years among much larger conflicts that have no concern about small business America or their financing marketplace.

Perfect storm sidetracked 504

The refinance rules seem to be among the hostages set aside by the rise of the Tea Party/Freedom Caucus in the House of Representatives, which curiously evolved as a force to counteract all things perceived to be favored by the GOP-business coalition. A long-time 504 lender who did not want his name mentioned, since he had been a part of direct conversations with several House members, described the 504 discussion as “..a struggle to explain how unsubsidized loans do not cost the federal budget anything.”

He went further to elaborate: “Part of the problem is a typical member of Congress can only lend their attention to you for 10 minutes–it’s a tall order to help them understand a two-tiered, private-public financing program, with a loan volume limit that must be authorized by Congress, but at the same time, does not have to be subsidized. We made some progress on refinance, but forget about FMLP–it’s dead–those conversations just went over everyone’s head.

In my judgment, the poor performance of the program has been due to a perfect storm of many factors that sidetracked the 504 program into its current funk, some of which were discussed is an earlier series of articles I wrote about the CDC/504 program challenges from 2009-present here: Part 1, Part 2, Part 3 & Part 4. Unfortunately, little progress has been made to navigate most of these problems and there are new headwinds aggravating the program, including:

1. Expansion of the 7(a) loan program to $5 million loan limits, and thereby allowing these loans to invade the commercial real estate turf in a more meaningful manner, occurred at the beginning of FY 2011 with little warning. Since a majority of 504 loans were previously used for larger CRE projects that were out of reach to the 7(a) program, many CDCs chafed at the invasion of their territory without ample time to transition into a larger marketplace themselves.

For dozens of smaller or rural CDCs, this change alone may spell extinction, as they serve smaller markets that previously did not have an competing alternative, but now do, albeit a more expensive financing product.

This 7(a) expansion was also timed when investors were starving for better yielding assets in a moribund economy, and guaranteed loans met that need for many, who in return have been paying out record-setting premiums over the past few years.

2. Interest rates! While the grudgingly slow economic recovery following the crisis has equally impacted everyone, remember that one of the principal advantages of 504 loans was their reliably lower, fixed-rate cost. Often, the bundled pricing offered between the senior mortgage and debenture rates was one to two points lower than the Prime Rate plus deal offered by a majority of 7(a) lenders.

But with interest rates stuck on a 3.25% prime since 2008, that differential narrowed considerably, taking away a key selling point for 504 loans, and the incentive to use 504 by many bank lenders facing shrinking interest margins and cut-throat competition.

3. Transition and in-fighting among competing interests in NADCO during these challenging years. Former long-time president Chris Crawford left the organization in 2012, which opened the door for plenty of new ideas ushered in with new president Beth Solomon as to where to go next. But obviously there was plenty of disagreement among some of the faithful, i.e. status quo. No one argues that there was plenty of turmoil at a very crucial time for the industry, but things seem to have finally quieted down with the emergence of new President & CEO Barbara Vohryzek in late 2014. See our my 2014 interview with Vohryzek here.

View the 504 program numbers for FY 2015 broken down with graphics
504 Loan Approval Analysis.

4. The post-EDF Resource Capital effect, which instituted significant changes as to how Certified Development Companies (CDCs) are governed, and started what many industry observers predict will be a ‘thinning of the herd.’ For many CDCs, especially in rural areas and those that serve as a part-time conduit for 504, the new rules add many disincentives to participate, especially in terms of cost and governance requirements. Expect the number of CDCs to fall off in the next couple of years.

5. Washington gridlock has contributed many problems to business as usual on the Hill, and even for a relatively small program such as 504, the effects are clear. How so? The general mood of “smaller government” crowd, combined with a tangible excuse on which to hang their hat (EDF Resource Capital) can be summarized in two words: CREED Act.

An industry insider, who also asked to remain anonymous, explained, “The refinance issue is stuck at the House Small Business Committee, where the General Counsel insists that an overhaul of the CDC industry is needed prior to passing the CREED Act. Worse, according to this source, no one has offered any specific proposals about exactly what changes are needed, pushing back for the industry to offer their own list of improvements.

Recently a majority of House members successfully circumvented the will of the Chairman of the House Small Business Committee, by maneuvering the Ex-Im Bank charter renewal to the House floor for a vote. It passed with a strong majority of members, but one source predicted there will be a price to pay in retribution. Whether or not SBA is part of the collateral damage remains to be seen.

Some good news is that on the Senate side, Sen. Jeanne Shaheen (D-N.H.) took to the Senate floor calling on legislators to support American small business owners by turning the bipartisan CREED Act into law.

6. Finally, SBA may be part of the problem. Several long-time 504 participants complained to me about the doubling-down by SBA’s Sacramento servicing center on debenture underwriting, slower loan processing, and a general indifference that many say has arisen about the program.

Who can help? In the words of one prominent voice in the 504 community, “the ‘C-Suite’[SBA political appointees] is out to lunch–they are all indifferent at this moment, looking for their next job, since the current one ends in less than a year.”

Where to go from here?

There’s been ample support in Congress standing by and ready to push the Commercial Real Estate & Economic Development (CREED Act), introduced in both sides of Congress in the Spring. The Obama administration has set aside money in two consecutive budgets to fund restoration of the refinance program. But still, there’s no visible progress of this legislation getting any closer to reality than the last one that died.

The FMLP is hardly missed by some, as several industry participants have moved on to garner resources to largely revive the 504 first mortgage secondary market from the ground up, without support of further stimulus or the federal government’s pooling efforts. Many proponents of 504 lending, including Jordan Blanchard, COO of 504 Fund Advisors, are optimistic: “It’s no secret that a vibrant secondary market drives SBA 7(a) production, and with 504 secondary market buyers increasing from 2-3 in 2013 to 7-8 and counting, I expect bright days ahead for 504 volume, given the emergence of a more robust 504 secondary market.”

What else is needed? How to get the program restored back to its former growth trajectory? One long-time and visible 504 lender, Chris Hurn, CEO of Fountainhead Commercial Capital, offers a vigorous argument for restoration of both the 504 refinance privileges and the FMLP program. “Converting conventional CRE loans to 504 loans invariably lowers financing costs and spreads transaction fees over a longer term, leaving more money in the business for local investment. That undeniably has a positive economic development impact.”

So far as the FMLP, Hurn frets that the program was never really able to demonstrate its potential before it was gone. “An active and robust 504 market of loan buyers and seller would allow the 504 program to get better traction with more lenders, who could improve yields and liquidity with a vibrant secondary market.”

And NADCO President Barbara A. Vohryzek is only looking upward and onward. “The reports of the 504 program’s death have been greatly exaggerated. Call me an incurable optimist but I see a bright future for the 504 Loan Program. CDCs are stepping up their game to meet the new challenges and we anticipate another bump in 504 volume this fiscal year,” she told me yesterday.

You just can’t keep this industry down, and that’s why I’m calling this coming year “The Year of the CDC.”

Let’s all hope she’s right.

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3 Responses to The 504 Loan Program Continues to Tread Water

  1. Jeff, thanks for your comments. Chris did mention default rates and among the many other story details, I failed to mention it in my article. Alas, life of researcher, writer, editor, publisher–did I mention we provide lender training?–and entrepreneur.

    The default rate to date for the 504 refinance loans is extraordinary: From $2.54 billion refinanced loans, charge-offs so far are just a few thousand over $2 million.

  2. Chris Hurn says:

    Thanks for your comments, Jeff.

    And just so you know, your comment about 504 refi performance was a victim of Charles’ fine editing. I mentioned that very fact to him, but alas, it stayed on the cutting-room floor. ;)

    Oh well!

    Hope you’re well.


  3. Jeff Sceranka says:

    This is one of the most thorough and thoughtful articles I have read regarding the 504 program.

    What is important to note as a smaller CDC in Southern California, is that the program’s results are not just tabulated in dollars or volumes, but the multitude of programs provided by the CDC’s that participate in the 504 program. The revenues generated by the 504 allows numerous outreach, economic development assistance, grants, and alternative loan programs.

    Of course, bringing back the refi program makes sense on all levels. The thing that is never addressed in these articles is the default rate of the loans that were made during the period this program was available. That should end any discussion about cost to the government.

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