Coyote Blog

The US Government has various rules on insurance companies that include a notification requirement if they are not going to renew a policy.  However, apparently this requirement is for a date earlier than most insurance companies have made their annual underwriting decisions (in my case often because I have not gotten them all the information they need).  So every year, like clockwork, I get notices on all my business insurance policies that they are not going to renew, and then like clockwork they (mostly) all renew.  Insurance companies comply by sending, it appears, everyone a non-renewal notice.  That way, they can't get in trouble for not informing you in time on the off-chance it actually does not renew.  So in practice, the regulatory requirement is both expensive and worthless.

Actually, it is worse than worthless, as the two times I was non-renewed for a policy it was impossible to differentiate their actual warnings that I might have an underwriting problem from these pro forma ones.  By forcing insurance companies to cry "wolf" constantly, I missed the real dangers.

Update 2/1/2016:  I will not comment further at the moment on Applied Underwriters as they are currently suing me to have this article below removed.  So you will need to look elsewhere for news on AU, of which there appears to be plenty.  For example, here and here.  The State of California Insurance Commission, via an Administrative Law Judge's decision, has ruled on the legality of the AU product discussed below.  That ruling (pdf) can be downloaded here.  I would love to comment on it but I will have to leave the evaluation to you.  If you can't read the whole thing pages 33 and 34 are worth your time, as well as the conclusions that begin on page 59.

After you read this, there are more updates on 4/18

Well, I have managed to get myself into a scam.  It is not your normal scam, like the ones that are run by some mafia boiler room with guys working under aliases.  This scam comes via a major insurance company called Applied Underwriters (working under the names California Insurance Company and Continental Indemnity Company) which is owned by Berkshire Hathaway and none other than Warren Buffett.  If you feel sorry for Warren Buffett and want to give him a large interest-free loan for an indeterminate number of years, this is your program.

Update 4/16:  Let me insert here that Applied Underwriters has sent me a letter threatening a libel suit if I do not take down this post and a parallel review at Yelp.  AU Takedown demand here (pdf).   The gist of the matter seems to be the word "scam".  By the text of their letter, they seem to believe that "scam" is libelous because their company is well-rated financially and that they provide reasonable claims service.  I concede both these facts.  However, I called it a "scam" because there is a big undisclosed cost to their product that was never mentioned in the sales process, and that could only be recognized by its omission in the contract I signed -- that there is nothing in the contract committing them to any time-frame under which to return deposits and excess premiums I have paid, which may well amount to hundreds of thousands of dollars.  This fact about the contract is confirmed by their customer service staff, who have said further that the typical time-frame to return such over-collections and deposits is 3-7 years after the contract ends, or at least 6-10 years after the first of the deposits was made.

So is this a "scam"?  I believe that this issue is costly enough, and hard enough to detect, and far enough outside of expected business practices to be called such.  You may have your own opinion, but ask yourself -- When you enter into, say, a lease and have to put down a security deposit, is it your reasonable expectation that the landlord has the right in your lease to keep your deposit for 3-7 years (or more) after you move out?  /Update

Anyway, let's take a step back and look at this in detail.

First, I need to give a bit of background on how workers comp works.  When you are a new company, they assign you an experience rating -- that is a multiplier of your premium based on past loss experience.  There is some default starting number that if I remember right, in most states, is a bit over 1.0x.  Each year, the workers comp world looks back at your past history and computes a new loss rating -- higher if you have had more payouts, lower if not.  Generally it is based on three years experience not counting the last year (so 2-4 years in the past).  Your future premiums get multiplied by this loss rating.

Several years ago we had a couple bad injuries that drove our loss number into the 1.7-1.9x area.   Neither were really due to a bad safety issue, but both involved workers in their seventies where a minor initial injury led to all sorts of complications.  Anyway, my agent at the time calls me one day a couple of weeks before renewal and says that none of the major companies will renew me.  This seemed odd to me -- I understood that my recent claims history was not good, but isn't that what the premium multiplier was for?  In fact, if my loss history returned to normal, they would make a fortune as I paid high rates based on old losses but had fewer new ones.

Apparently, though, insurance companies have fixed rules that keep them from underwriting higher loss ratings.  Probably for the same reason Vegas won't take action on Ivy League football games any more -- just too much variability.  I found out later with my new broker we could probably have overcome this, but I learned that too late.

My broker at the time put me into a 3-year program from Applied Underwriters, in part because they were taking everybody.  This program was set up differently from most workers comp programs.  You had a basic policy, but there was a second (almost indecipherable to laymen) reinsurance agreement that adjusted the rates of the basic policy based on you actual claims.   Here is the agreement (pdf)  In other words, based on your claims, they would figure up at the end how much you owed and what your premium multiplier would be.

I saw two red flags that I ignored in signing up.  1)  The reinsurance agreement was impossible to understand, violating one of my foundational rules that I shouldn't sign things I don't understand.  And 2) The rate structure was very suspicious.  They touted a rate structure that could go as low as, say, $100,000 a year and was capped around $400,000 a year.  But when you pulled out a calculator, the $100,000 was virtually unobtainable.  It would require about zero claims.  If there were any claims at all, even for a few bandaids, the price would march up to $400,000 really fast.  It was the equivalent of a credit card teaser rate, and it should have made me suspicious.

Anyway, I was desperate.  For a business like mine, being told I had no workers comp insurance just a few weeks before the old policy ran out was a death sentence.  No one would write me or even quote me a policy that fast.  So I took the Applied Underwriters offer.  Shame on me, I should have worked on this much harder.

I won't bore you further with my voyage of discovery in trying to figure out how this thing works.  I will just tell you the results that I have found.  There are apparently other companies with similar issues, one of which is documented here: Applied Underwriter Suit (pdf)Newsletter publisher objected to scan of article, so I have taken it down at their request.  Here is a link to roughly the same article.

I spent hours and hours trying to figure out AU's statements.  There is a whole set of terminology to learn that is actually not used in most of the rest of the workers comp world.  The key page of the statement is page 7, which I will show below because it highlights several of the issues with Applied.  Page 7 is the page where the monthly premium is "calculated".  I have added the red numbers and arrows for the discussion below.

Here are some of the Applied Underwriter problems:

1. Large deposits that must be made each year and may never be returned.    You can see that I am making deposits over $40,000 a year.  And that is each year.  The first year deposit is not returned.  The second year and third year are just added to it.  And I have found out since I joined this program that they are not contractually obligated to return them in any time frame.  Maybe some guy who was hurt in his thirties has a relapse and claims more money when he is 75.  Gotta keep your deposit just in case, don't we?  The timing of the return of your deposits (and overpaid premiums below) is entirely at their discretion, and that has been confirmed by their customer service staff.  In fact, their standard answer is that on average, such monies are not returned to customers for 3-7 years after the contract ends, or at least 6-10 years after the first deposits were made.
2. Premiums based on the worst of your experience and their estimate of your losses, and they keep the difference for years and years.   For those in the same trap as me, I will try to explain the numbers above.  The estimated loss pick containment at the top is basically their estimate of your losses.  Note that it drives every number on the page and is basically their arbitrary number -- they could have set it anywhere.  The loss pick containment to date is just pro rated for the amount of the year that has gone by.  The 65% is an arbitrary number.    The $25,278 is my actual losses to date.  You can see where I point with #2 above, though, that my losses are irrelevant to my premiums.  They take the higher of my losses and what is essentially their estimate of my losses and I pay based on that.   Note that their higher number is not based on the reserved amounts on actual claims -- the $25,278 includes their reserves.  It is just the number they established at the beginning of my policy they think my claims are going to be and gosh darnit they are going to stick to that (and my claims even in my worst year in history were never even half of their estimate).  Yes, at the end of the policy if my losses stay low, they owe me money back for all the premium they overcharged me based on their arbitrarily high estimates.  But see #1 above -- there is no time horizon under which they have to return the money.  They can keep it for years and years.
3. The final premium is, after all these calculations, entirely arbitrary.  So after this loss calculation (which essentially just defaults to their arbitrarily high estimate and not my actual loss history) they do some premium calculations.  These actually sort of make sense if you stare at the agreements for a really long time.  But then we get to the line I point to in red labelled 3.  It is the actual amount I owe.  But it does not foot to any other number on the page.  How do they come up with this?  They won't say.  To anyone.  It might as well be arbitrary.  I actually had some dead time and took all my reports and tried to regress to a formula they use for this, but I couldn't figure it out.   So all the calculation on this page is just a sham, it's the mechanical wizard in the Wizard of Oz.  It looks good, but does not actually directly lead to what you are billed.

So I thought I understood my problems.  I put in large deposits and overpaid premiums based on arbitrarily high loss estimates they make -- all of which will take me years and years of effort to maybe get back.  It turns out that I likely will have a third problem.  In the lawsuit linked above, the plaintiff complains that when they left the program after three years, Applied arbitrarily wrote up all their estimated losses on open claims to stratospheric levels and then demanded a large final premium payment at the end.  Folks on Yelp complain of the same thing.  You should know how this works by now -- the plaintiff will theoretically get all this back someday, maybe, when the claims prove to be less costly, but in the mean time Warren Buffet gets to invest the money for years and years (cost of capital = 0) until it is returned.

This is why I think Applied Underwriters actually likes companies with high lost histories.  Rather than costs, losses for them are excuses to over-collect on deposits and premiums -- money that can then be invested and held for years free of charge.

As an aside, I want to thank my new agents at Interwest Insurance for helping decipher all of this.  They actually flew a guy in to help me understand this policy.  They didn't get me into it, but they are helping me pick up the pieces as best we can.

Once upon a time, government officials decided it would help them keep their jobs if they could claim they had expanded the middle class.  Unfortunately, none of them really understood economics or even the historical factors that led to the emergence of the middle class in the first place.  But they did know two things:  Middle class people tended to own their own homes, and they sent their kids to college.

So in true cargo cult fashion, they decided to increase the middle class by promoting these markers of being middle class.  They threw the Federal government strongly behind promoting home ownership and college education.  A large part of this effort entailed offering easy debt financing for housing and education.  Because the whole point was to add poorer people to the middle class, their was a strong push to strip away traditional underwriting criteria for these loans (e.g. down payments, credit history, actual income to pay debt, etc.)

We know what happened in the housing market.  The government promoted home ownership with easy loans, and made these loans a favorite investment by giving them a preferential treatment in the capital requirements for banks.  And then the bubble burst, with the government taking the blame for the bubble.  Just kidding, the government blamed private lenders for their lax underwriting standards, conviniently forgetting that every President since Reagan had encouraged such laxity (they called it something else, like "giving access to the poor", but it means the same thing).

A similar bubble is just about to burst in the college loan market, and this time it will be much harder for the government to blame private lenders, since the government effectively nationalized the market several years ago and for years has been the source of at least 90% of all college loans.  In the Wall Street Journal today, it was reported that student loans are now the largest component of consumer debt, and growing

Further, a Fed report yesterday said that student loan diliquencies have jumped substantially of late

The scary part was found by Zero Hedge in the footnotes of the report, which admit that this number is understated by as much as half, meaning the true delinquency rate of student debt may be north of 20%.

The Journal article linked above explains why this is:

Nearly all student loans—93% of them last year—are made directly by the government, which asks little or nothing about borrowers' ability to repay, or about what sort of education they intend to pursue.

President Barack Obama championed easy-to-get loans during the campaign, calling higher education "an economic imperative in the 21st century." A spokesman for Education Secretary Arne Duncan said the goal is "to make student loans available to as many people as possible," and requiring minimum credit scores would block many Americans

Any of this sound familiar?  I seldom learn much from anecdotes in new stories since it is too easy to craft a stirring anecdote on either side of just about any issue.  But I was amazed at the story of the woman who was issued $184,500 in student debt to send her son to college when her entire income is a $1600 a month disability check.

I don't have time today to link all the evidence, but the combination of crashing real estate markets and the Chinese government jamming liquidity into its banks tells me the China bubble is bursting as we speak.

This is an interesting test of the Austrian view of depressions vs. the Keynesian / Krugman / Thomas Friedman / MITI view of government-orchestrated prosperity.  If the latter are right, then China is doing more right to keep their economy going than any country in history and you should go invest all your money in Chinese real estate.

However, if one believes the Austrian model about government-enforced mis-allocation of capital and labor leading to bubbles and crashes; if one believes that the technocrat-beloved MITI was largely responsible for the Japanese lost decade; if one believes that the US govenrment through articially low interest rates and government-directed reductions in underwriting quality helped create the housing bubble -- then the mother of all crashes is looming in China.  Because no country has done more to reallocate resources and capital based on the whims of a few technocrats  and well-connected industrialists than has China.  After all, this is why Thomas Friedman loves China, that it does not rely on the judgement of millions of individuals to allocate capital, but instead on the finger pointing of a few at the top.

This is pretty incredible.  It's like the last two years didn't even happen.

A national consumer coalition plans to file a series of landmark federal fair housing complaints beginning Dec. 6, challenging a widespread practice by banks and mortgage lenders: requiring borrowers who apply for FHA loans to have FICO credit scores well above the 580 minimum set by the FHA for qualified applicants with 3.5 percent down payments....

Because FHA insures lenders against losses from serious delinquency or foreclosure, there is "no legitimate business justification" for rejecting applicants solely on the basis of FICO scores that are acceptable to FHA, the complaints contend.

Subprime mortgage customers are generally defined as those under a credit score of 620.  I am surprised that anyone in this environment is offering 3.5% down to any buyer  (though here is the government actually advertising the fact).  But giving 3.5% down to subprime borrowers?

Even with the FHA guarantee, banks have learned that the cost of default for them is not zero.  Only someone who has been in a cave for two years could somehow ascribe this action to discrimination rather than an obvious reaction to the ongoing mortgage crisis.  The government is still out acting irresponsibly, and when private institutions (who actually have to live with the cost of their decisions) try to behave like adults, they get hauled into court.

By the way, this sure does seem to bolster the argument that community banking standards and the pressure from the government and community groups to drop lending standards played a large role in the housing crisis.  If we are seeing this kind of pressure even after the housing disaster, what kind of pressure was at work, say, in 2005?

Via Mark Calabria, who has more

Update: Flashback

"In 1995, HUD announced a National Homeownership Strategy built upon the liberalization of underwriting standards nationally. It entered into a partnership with most of the private mortgage industry, announcing that "Lending institutions, secondary market investors, mortgage insurers, and other members of the partnership [including Countrywide] should work collaboratively to reduce homebuyer downpayment requirements."

The upshot? In 1990, one in 200 home purchase loans (all government insured) had a down payment of less than or equal to 3%. By 2006 an estimated 30% of all home buyers put no money down.

"The financial crisis was triggered by a reckless departure from tried and true, common-sense loan underwriting practices," Sheila Bair, chair of the Federal Deposit Insurance Corporation, noted this June. One needs to look no further than HUD's affordable housing policies for the source of this "reckless departure." If the mortgage finance industry hadn't been forced to abandon traditional underwriting standards on behalf of an affordable housing policy, the mortgage meltdown and taxpayer bailouts would not have occurred."

I have come to the conclusion that politicians believe Americans all have Alzheimers.  And, given the lamentable state of the media, they may be right.

Example 1

We can argue about stimulus and the Depression all we want, but I had, until the last few days, thought the absolute one thing we all 100% agreed on is that the Smoot-Hawley tariffs and the trade war they sparked were one of the leading causes of the worldwide economic death spiral in the late 20's and 30's.  Or not:

The stimulus bill passed by the House Wednesday contains a controversial provision that would mostly bar foreign steel and iron from the infrastructure projects laid out by the $819 billion economic package. A Senate version, yet to be acted upon, goes further, requiring, with few exceptions, that all stimulus-funded projects use only American-made equipment and goods.

Here is a nice story of another "Buy American" steel fiasco.

Example 2

Last year -- I am talking about just 3 months ago -- I thought it was fairly clear that the immediate cause for the financial meltdown for which the TARP bailout was being crafted was the systematic relaxation of underwriting standards that led to large numbers of loans (and their lenders, securitizers, etc) going belly-up.  Folks could argue whether this was because of deregulation or greed or government distortions and interventions, but I thought there was not doubt that poor credit judgment and excessively free credit were at the heart of the problem.  Or not:

House Financial Services Committee Chairman Barney Frank said President Barack Obama will require banks receiving government aid to lend more to businesses and consumers, saying the Bush administration "made a mistake" by not setting stricter rules for institutions getting funds from the $700 billion financial-rescue package.

"I think you're going to see the Obama administration, having learned from that, push for much more lending," Frank said today on ABC's This Week. "There are going to be some real rules in there."

So Frank and Obama are upset that the bailout of banks that were overgenerous on credit did not include provisions to force them to be more generous with credit?

Final thought: At the end of the day, businesses and individuals have a felt need to deleverage.  That is going to cause a recession, end of story.  The Congress's and Obama Administration's obsession with short-circuiting this sensible desire to reduce debt is not only counter-productive, it is offensive.  Banks are sensibly trying to strengthen their balance sheets, but the government wants to stop them.  Individuals are trying to cut back on spending, reduce debt, and save more.  Again, the government wants to stop them, by going to debt and spending for them if consumers won't do it on their own.

As usual, Michael Lewis is a great and informative read, trying to unravel the whole subprime mortgage / CDS / CDO bundle somewhat for laymen.  The article does not excerpt well, but I would summarize it in saying he identified four mistakes by the financial world.  The first two I would describe as real problems but not really new mistakes -- something similar could have been said about S&L's in the 1980's.  These are:

1. A lot of subprime loans were issued to people with no freaking hope of repaying them, in an incredible general lowering of underwriting standards.  (we all should remember, though, the government and the media was trumpeting this as good news -- increase in home ownership rates, blah blah blah).
2. People who bought these securities grossly underestimated the default risks, particularly in the crappiest tranches  (securitized packages of loans are resold in tiers, with a AAA tranche getting first call on any payouts, and the tail end BBB tier getting high interest rates but who takes the first principal losses if the loans default).

   But Lewis highlights two mistakes that are in some sense brand new.  These mistakes were effectively vast increases in leverage that acted as a multiplier for the subprime problem, while simultaneously spreading the problem into the hands of AAA investors who accepted the higher returns without paying too much attention to how they were obtained

3. Someone started scooping up the BBB tranches from various securities packages, bundled these together, and somehow got a ratings agency to declare that the top 60% tranche of these repackaged dog turds were AAA. 
4. Credit default swaps, originally insurance policies on loan portfolios, turned into a sort of futures market on subprime mortgage packages.  But, unlike futures markets, say in oil, where the futures trading volume are generally well under the total volumes of the underlying commodity flowing around the world, CDS values grew to as much as 100x the underlying commodity volume (in this case subprime mortgage securities).  CDS's went from a risk-management tool to a naked side-bet.

This is interesting stuff, and it was really only reading this piece that I think I started to understand #4 above (though if readers think I am describing this wrong, let me know).  All of this leads me to a few thoughts:

• Nothing about this convinces me any of these firms need to be saved or bailed out.  Let them die.  Maybe the guys who rebuild the industry in their place will be smarter and more careful.  The country is going to face a recession whether Wall Street is bailed out or not -- too much (paper) value disappeared from consumer's net worths (or their perceptions of their net worth) for that not to be the case.  I lived through Texas in the 1980s when the S&L industry went bust almost to the last institution.   Nearly every one of the top 10 banks in the state went into FDIC recievership. 
• I have seen people observe that this is an indictment of capitalism because so many people made such bad mistakes.  Sure.  No one said capitalism is a gaurantee against stupidity, or even fraud.  The difference is that the consequences of said stupidity and fraud have to be less in a free market system than if the same people had the power of cersion via government.  In a free market, these guys will fail and be wiped out and get washed away.  The people who they drag down may consider themselves to be innocent, but they participated of their own free will -- if they did not understand what they were doing, that is their problem.  In a statist system, you still have mistakes like this, but they are infinitely more catastrophic, as the stakes in play are often higher.  And the people who made the mistakes are never punished financially, because they are in charge of the machinery of state  (or friends of those in charge).  They make damn sure the power of the state is used to make everyone else pay for their mistake, kind of like ... this $700 billion bailout.
• Lewis seems to have a hypothesis that the main system change that allowed all this to happen was the shift in ownership structure from partnerships to publicly-held corporations.  And certainly you do get some added agency risks with this, though I find this explanation a bit shallow.  I do think that folks with money are going to approach Wall Street "experts" and rating agencies with a lot more skepticism for a long time, and that can't be a bad thing.
• The opportunity really exists for someone smart to start a brand new rating agency from scratch.  The only reason the current ones won't get wept away is simply that there are not many alternatives right now.  Warren Buffett should partner with someone well-connected with the new administration (Maybe Larry Summers, since there is no way he will survive a confirmation hearing with his men-are-from-large-standard-deviations-women-are-from-narrow-distributions baggage.)
• Lewis is unfair in depicting all the mortgage lenders as predatory.  I am sure some were cheats, but remember that as far as Congress, the Administration, the Federal Government, and the media were concerned, these lenders making subprime loans were doing God's work -- they were expanding home ownership and bringing the dream of owning a home to poor people historically redlined, blah blah blah.  It is only with hindsight that we demonize them for doing the wrong thing -- at the time, absolutely everyone on in the country was pushing them to do exactly what they did.  This is also why Democrats struggle to suggest a resposive regulatory package to this whole mess, as any real reform would have to address minimum underwriting standards, which in turn would have the direct effect of limiting lending to the poor, an outcome with which no Democrat wants to be associated.

Update:  Just to be clear, as I have said before, this is about half of what happened.  There are really two stories, and usually authors focus on one or the other.  Story 1 is the steps taken by the Federal Government  (Fannie, Freddie, Community Reinvestment Act, mortgage interest deduction, low interest rates) that fueled the housing bubble and the expansion of credit to questionable borrowers.  It is described here, among other places.  Story 2 is the one above, how private firms decided not only to purchase these questionable loans made on bubble-inflated assets, but to leverage these assets up to staggering levels. 

OK, I know burn-out is setting in.  I certainly think that explains, in part, why the House voted for a demonstrably worse bill than they voted against the week before.  But John Moore has a number links to an interesting set of charts from the Milken Institute on the financial meltdown.

They hit on many of the things I discussed earlier, but put a greater emphasis on 1) securitization, and the effect it had on good underwriting standards and 2) on interest rates as a driver of the housing bubble.

Update:  And an interesting post on the link between credit default swaps and short-selling.  My personal view is that credit default swaps will someday be looked at like earthquake insurance -- nice premiums today, but too much systematic risk, too much certainty that in 10 or 20 years there will be an event that forces nearly every policy to pay simultaneously, wiping out the insurer.  You can't get earthquake insurance, and you nearly can't get hurricane insurance, and I think the default insurance market may go the same way.  Or, as a minimum, the price is going so high few people will buy it.  This is not a market failure, it is a market lesson learned and adjustment to reality.

Update #2:  Even more from economists on the rush to bailout.

Via Carpe Diem, comes this September 30, 1999 NY Times story:

In a move that could help increase home ownership rates among
minorities and low-income consumers, the Fannie Mae Corporation is
easing the credit requirements on loans that it will purchase from
banks and other lenders.

The action, which will begin as a
pilot program involving 24 banks in 15 markets -- including the New
York metropolitan region -- will encourage those banks to extend home
mortgages to individuals whose credit is generally not good enough to
qualify for conventional loans. Fannie Mae officials say they hope to
make it a nationwide program by next spring.

Fannie Mae, the
nation's biggest underwriter of home mortgages, has been under
increasing pressure from the Clinton Administration to expand mortgage
loans among low and moderate income people and felt pressure from stock
holders to maintain its phenomenal growth in profits.

In
addition, banks, thrift institutions and mortgage companies have been
pressing Fannie Mae to help them make more loans to so-called subprime
borrowers. These borrowers whose incomes, credit ratings and savings
are not good enough to qualify for conventional loans, can only get
loans from finance companies that charge much higher interest rates --
anywhere from three to four percentage points higher than conventional
loans.

''Fannie Mae has expanded home ownership for millions of
families in the 1990's by reducing down payment requirements,'' said
Franklin D. Raines, Fannie Mae's chairman and chief executive officer.
''Yet there remain too many borrowers whose credit is just a notch
below what our underwriting has required who have been relegated to
paying significantly higher mortgage rates in the so-called subprime
market.''

Demographic information on these borrowers is
sketchy. But at least one study indicates that 18 percent of the loans
in the subprime market went to black borrowers, compared to 5 per cent
of loans in the conventional loan market.

In moving, even
tentatively, into this new area of lending, Fannie Mae is taking on
significantly more risk, which may not pose any difficulties during
flush economic times. But the government-subsidized corporation may run
into trouble in an economic downturn, prompting a government rescue
similar to that of the savings and loan industry in the 1980's.

''From
the perspective of many people, including me, this is another thrift
industry growing up around us,'' said Peter Wallison a resident fellow
at the American Enterprise Institute. ''If they fail, the government
will have to step up and bail them out the way it stepped up and bailed
out the thrift industry.''

Those heartless free marketing guys at the AEI -- always predicting doom every time we open our hearts to poor people.  Bailout?  What ridiculous scare-mongering.

Note that this article is one in a series of articles on small business how-to's.  Past series have covered how to buy a business, labor audits, sales taxes, and workers comp.

I recently went through the process of obtaining an SBA (Small Business Administration) loan.  These are loans that are what I call "cash flow" loans, secured more by the companies earnings rather than collateral (though collateral may be required, see below).  SBA loans are written by private banks to standards set by the government.  If these standards are met, then bank loans under this program get a partial guarantee from the US government.

Before I go on to describe the process, I feel compelled to note that as a libertarian who does not believe the SBA should even exist and who believes that such loan guarantees are a subsidy program that should be eliminated, I was obviously conflicted by whether to seek out such a loan.  What finally made the decision for me is that this government program has crowded out all other private options.  Banks get about the same rate for an SBA loan as they would for a commercial loan without the guarantee.  Since the guarantee is out there and doesn't cost the bank anything, the bank has no reason not to insist on it?  Therefore, as a small company in the SBA size range, there just are not any banks willing to lend without the SBA guarantee.  This does not mean that in a free market without the SBA there would be no loans - it just means that when such a free subsidy program exists, banks are going to take it.

Types of Loans

The following is a gross simplification, but for a small company, there are basically two types of loans: secured loans and cash flow loans.  Secured loans are by far the most common for small businesses.  I, like nearly every entrepreneur I know, have had to pledge my house at various times as collateral for loans.  While it is fairly easy in today's market for a small company to get an equipment loan (typically lease-finance of a purchase) secured by hard assets, few lenders will provide loans for general business and working capital needs unless they are secured by something tangible -- homes, vehicles, receivables, etc. 

However, most businesses need capital for more things than just to buy hard goods.  Seasonal businesses may need loans to pay the rent in off-seasons, retail businesses need money to grow inventory and pre-pay for new leases, while opening new divisions may require paying salaries well in advance of first revenues.  Unfortunately, most businesses that claim to be business banks have no desire or talent to understand a business well enough to make a cash flow loan.  I am not talking about just Ethyl's Bank, but large banks like Bank of America and Wells Fargo who were stumped when I wanted to discuss some unique financing needs in my business.  I know people with a half million dollars a year in free cash flow out of their business who have trouble getting bankers to make unsecured cash flow loans.  And, as mentioned above, those who do make cash flow loans typically insist on having the SBA guarantee.

How an SBA Loan Works

I will not pretend to be an expert on all the intricacies and rules.  The SBA has a number of programs, offering loans of different lengths of time and for different purposes.  The SBA has programs for both revolving lines of credit as well as standard 10-15 year loans.  Each of these programs has different under-writing criteria, fees, and limitations, which your banker will have to explain to you.  Most SBA loans, including mine, fall under the section 7(a) program.  The SBA site tries to explain some of this.

As stated in the intro, an SBA 7(a) loan actually is issued by a bank, but to SBA underwriting criteria and with an SBA guarantee.  The SBA only guarantees a portion of the loan, something like 50-75% depending on the exact loan type, with the bank taking the rest of the risk.  These loans are issued at a floating rate of prime plus a percentage, and the SBA has rules that caps the rates as well as fees the bank can charge.  The SBA charges a substantial fee, in the 2-3% of total loan value, up front to the borrower for the guarantee.

Banks participate in the program in one of two ways.  Most any bank can originate an SBA loan, collecting all the (very substantial) paperwork needed by the SBA and forwarding it to the SBA for approval.  In addition to the underwriting time at the bank, the SBA can take many weeks to complete this analysis.   A smaller subset of banks have been pre-approved by the SBA to act as their underwriting agent - called a preferred lender or PLP.  This means that they can do the SBA's analysis for them.  This often greatly accelerates the process.  My total time form the bank's first data request to the final loan closing was less than a month, which is very fast.

Choosing the Bank is Critical

From the section above, it should be obvious that you should strongly consider working through a bank that has the preferred lender status with the SBA.  Note that having  or not having this status does not necessarily correlate with bank size.  The "expert" I was hooked up with at Bank of America (my main bank) was useless, and told me in so many words that it would be impossible for me to ever get an SBA loan.  I ended up working with Silver State Bank, a relatively new business bank out of Nevada.  They had the whole process automated, and when combined with a very knowledgeable banker on the front end named Jerry Woods here in Phoenix, the process was as smooth as silk and very, very fast.  In fact, I got the whole loan done in less time than it took BofA two years ago to do my line of credit.

Costs and Other Considerations

SBA loans are not cheap, and I would strongly urge you to pursue secured asset-backed loans as far as you can.  My total fees, including the cost of the guarantee, ran to about 3% of the total loan value.  In addition, I STILL had to put up collateral to back the non-guaranteed portion of the loan.  In retrospect, I think I did a bad job of negotiating with my banker on this.  No matter how good they are, bankers are still bankers and are going to attach every asset that can sit still for collateral whether they really need it or not.  I should have pushed back harder on this issue.  Overall, though, I am excited that I now have the capital to continue to grow my business.

PS-  If you want to enjoy some of this capital at work, come to Lake Havasu and rent a jet ski for a day!  All those other entrepreneurs out there are investing money in dead-end stuff like microchips and improved manufacturing --  Ha!  There is nothing like being able to tear around a big lake on 110HP to really make America competitive!