SBA Lending Analysis Part 1: A History of Default Rates

Welcome to the first part of Jamestown Capital's series on SBA Loans. In this edition, we're going to take a deep-dive into the last 35 years of SBA lending, exploring the underlying factors driving default rates, and how SBA Loans fared during the three recessions in this time period.

If you're a searcher looking for specific learnings from SBA default data to guide your next acquisition, feel free to skip ahead to Part 2. Here's a summary of key takeaways:

For both investors and searchers, SBA loans provide a unique arbitrage opportunity via a government backed guarantee. Loans are issued at significantly lower rates than they would be in the absence of the government guarantee
SBA loan default rates remained at low levels during two of the past three recessions while other asset classes suffered
Recently, the federal government has shown a willingness to go to great lengths to protect small businesses, namely the PPP and SBA Debt Forgiveness programs

Before getting into the numbers, let’s take a quick moment to recap what SBA loans are. The United States Small Business Administration (SBA) provides a government-backed payment guaranty to small business loans. This allows banks to lend to small businesses that might otherwise struggle to secure financing. The SBA will often guaranty over 75% of the loan's value, allowing for banks to lend at artificially low rates. These loans have helped countless entrepreneurs grow their businesses, create jobs, and contribute to the broader economy. From a searcher's perspective, these loans offer acquisition financing at inorganically low rates.

The SBA offers a variety of loan types, and in this article, we'll focus on SBA 7(a) loans. SBA 7(a) loans are the most popular type of loan for searchers. Down-payments can be as low as 10%, and rates can be as low as the prime rate (generally 2-3 points above the risk-free rate). While 7(a) loans can allow searchers to access capital at terms that would otherwise be unavailable to them, they come with restrictions like a maximum ten year term, and a $5m notional limit.

In the last 35 years, despite major recessions, SBA loan activity has an experienced an impressive CAGR of 6.9%, from total loan approvals of $1.2B 1991 to $10.6B in 2023. Loan activity saw an especially notable increase in the aftermath of the covid pandemic in 2021, as an increasing number of business owners retired, and the search space grew in popularity.

Default rates are an important lens into the health of small business in America. Since 1990, the average 5 year default rate for SBA 7A loans is 5.2%. Compared to "safer" or more traditional asset classes such as investment-grade debt (less than 1% default rate), these default rates may at first appear on the high end. However, as with any investment, risks must be weighed against rewards. While SBA loans default at 5.2%, the underlying businesses can generate annualized returns in excess of 30%. SBA loans, from the perspective of the borrowers, investors, and lenders, provide a unique statistical arbitrage opportunity via the government-backed guaranty.

SBA default rates in are impacted by a wide variety of factors, chiefly:

Macroeconomic conditions
Interest rates
Industry
Business/Operator Quality

SBA Lenders attempt to control for all of these factors when making loans. As banks cannot predict future rate environments, the vast majority of SBA 7(a) loans are variable rate loans, where lenders attempt to offload a portion of their interest rate risk to the borrower. Even when lenders make variable rate loans, they are still exposed to increased risk of default as rates rise. Lenders can further attempt to hedge their remaining risks via credit default and interest rate swaps.

In a lender's ideal world, they would price all of their loans perfectly, and default rates would be stable and predictable. From the default data, we can see that this is clearly not the case - difficult to predict variables drive default rates. In the following sections, we'll dive into the different default regimes over the past 35 years and explain the driving factors.

Since 1990, America has experienced three recessions:

Dotcom bubble (Q1 '21 -> Q3 '21)
Subprime mortgage crisis (Q4 '07 -> Q2 '09)
COVID-19 pandemic (Q1 '20 -> Q2 '20)

Each of these cases had very distinct impacts (or lack thereof) on default rates.

Dotcom Bubble

Main Street Continues to Thrive

From 1995 to 2000, the US economy grew at an annualized rate of 4.1%, by far the highest 5 year period of growth in the last 40 years. The NASDAQ index increased over 10x during this time period. To prevent the economy from overheating, the fed kept interest rates moderately high, and the prime rate in turn stayed above 8%. This was a very healthy environment for SBA lending, with average default rates for the period at 4.8%.

In March of 2000, the dotcom bubble began to burst, and by mid 2002, the NASDAQ index had lost over 80% of its value. The US economy dipped into recession in Q1 of 2001, and did not emerge until Q4 of 2001.

Unlike the Great Recession, the 2001 recession did not impact SBA loan default rates for a number of reasons:

The recession was relatively mild
The previous 10 years (the longest time between recessions until that point) were extremely strong
The fed had plenty of dry-powder and quickly lowered rates from 6.5% to 2%. Variable rate loan payments became much easier to meet
The losses did not particularly bleed to "main street". The primary under-performers were larger technology firms

Housing Crisis

SBA Loans Under Pressure

The housing crisis provides a stark contrast to the dotcom bubble. The lead-up to the recession was marked by a series of unique events that culminated in the Great Recession. In the aftermath of the dotcom bubble, the fed lowered interest rates, and lending institutions increasingly issued lower quality "sub-prime" loans. Financial leverage also increased during this time, in-part due to the increased popularity of derivatives linked to these loans.

Following this period of low rates and sub-prime lending, from 2004 to 2006, the fed aggressively raised interest rates from 1% to 5.25%, raising the cost of mortgages and lowering property values. Amid falling property values, sub-prime lenders began to default, and eventually larger institutions (global banks and insurers) were brought down with them. The subsequent liquidity drought affected all aspects of the economy - particularly small businesses sensitive to discretionary spending.

SBA loans performed particularly poorly during the Great Recession for a number of reasons:

The recession was particularly deep - the most severe since the great depression
Rising interest rates in the lead up to the recession put pressure on small businesses exposed to variable rate loans
The fed did not lower rates quick enough. It took two years to lower rates to zero, in contrast to the covid recession when rates were lowered to zero in a quarter
There was little targeted government intervention in small businesses

Covid

Low Default Rates Amid Unprecedented Stimulus

In March of 2020, concerns regarding the coronavirus led much of the American and global economy to shut down. Small businesses, many of which rely on foot-traffic, were hit particularly hard by stay-at-home orders and social distancing requirements. In the US, the federal government reacted particularly forcefully to limit the damage to small business. The first measure was PPP (Paycheck Protection Program) loans. These loans were issued to help small businesses meet payroll while the economy was shut down, and were later forgiven, with certain restrictions. In total, $953 billion was disseminated as part of the PPP program. The second measure was the SBA Debt Relief program, that allowed businesses to forgo six months of both principal and interest payments. While many criticize the cost and scope of these programs, it is undeniable that they prevented many small businesses from default.

SBA default rates were largely unaffected by covid, primarily due to government intervention:

Targeted programs subsidized small businesses - PPP Loans and SBA Debt Forgiveness left many businesses in better shape than they were in before the recession
Rates were lowered to zero almost immediately
Many SBA loan heavy industries, such as contracting, became significantly more in-demand due to a transition to work-from-home
Consumer spending rebounded within 6 months, in contrast to the GFC when consumer spending took 2 years to rebound.

The history of SBA lending over the past 35 years provides valuable insights into the resilience of small businesses in the face of economic cycles and recessions. As we delve deeper into facets of SBA lending, we will come back to these macroeconomic shocks for insights.

In Part 2 of this series, we will explore industry trends in SBA Lending, guiding searchers and investors to the strongest industries for their next acquisition.

Jamestown Capital LLC

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