A Joint Article By Mark Sunshine and Robert Blum
Unfortunately, the Obama Administration isn’t proposing much to help restart lending to small and medium sized enterprises (“SMEs”). While SME’s make up the backbone of the U.S. economy and provide most of its job creation, the credit crisis is making them economic road kill. SME’s are small manufacturing and service businesses are innocent victims; they pay their bills, employ workers and aren’t particularly over leveraged. However, the credit crisis doesn’t discriminate between the “guilty” and the “innocent”; it is an equal opportunity business killer. Regrettably, while Washington knows that that economic recovery requires a normally functioning and sound small business lending sector, the Obama Administration hasn’t found the right policy initiatives to restart SME lending. Even worse, pumping trillions into zombie banks has the unintended side effect of enabling these banks to suck the economic life out of SMEs.
Fortunately, there are relatively inexpensive measures that can quickly restart SME lending on a safe and sound basis. Targeted modifications in the tax code and mutual fund regulations can change the landscape of SME lending by dramatically enlarging the capital base and types of lenders that lend to SMEs.
TARP isn’t working for healthy SMEs.
Healthy SMEs are getting squeezed by lenders and are actually getting hit harder by the credit crisis than many troubled borrowers. SMEs have three challenges that are dramatically raising their borrowing costs and reducing their options.
First, the pricing of new loans has been turned upside down. Instead of setting interest rates based upon risk (i.e., lower risk results in lower interest rates) many bank loans have a “zombie tax” that is charged to good borrowers and covers the cost of carrying bad credits. Banks are setting interest rates based upon the borrower’s ability to pay which means that the best credits are paying the most and subsidizing bad credits that need help. And, it is the TARP banks that seem to be the biggest zombie taxers.
Second, SMEs lack negotiating leverage to get the zombie tax reduced or eliminated. By definition SMEs are small loan borrowers and while as a group they are important to lenders, individually they aren’t important enough to lenders to make a material financial difference.
And third, the non-bank lending sector, which makes up a significant portion of SME lending, is getting hammered by the credit crisis and is dramatically shrinking. Non-bank alternatives for SMEs to borrow money are disappearing at an increasing pace. Even worse, healthy non-bank lenders are themselves being charged zombie taxes on their capital which they are passing on to SME borrowers.
These factors are combining to disenfranchise SMEs from the financial system at the very time that we need them investing and creating jobs and growth.
What can Obama do now?
There are two easy to implement principal policy initiatives that the Obama Administration can quickly do to restart healthy SME lending. As contrasted to the multi-trillion dollar TARP program, these policy initiatives are simple technical changes to regulations that will encourage private capital to invest in small business lending. And, they are deficit neutral to tax positive (i.e., if they work they will increase tax revenue without any cost).
Solution #1 – Modify tax rules to encourage passive investment in limited partnerships that are in the business of SME lending
Under the current tax rules there is significant tax risk if a person or entity makes a passive investment and becomes a limited partner in a limited partnership that lends to SMEs. The IRS says that these limited partners are engaged in a “trade or business” by virtue of their passive investment. That tax rule basically excludes foreigners, not-for-profit organizations, pension funds and certain other entities from investing in most unregulated funds that make loans to SMEs. This tax rule puts the tax exempt status of not-for-profits and pension funds at risk and could subject foreigners to U.S. taxation on their global earnings and profits.
And, most U.S. citizens have a similar state taxation issue. As an example, if a Florida resident (a state with no personal income tax) makes a passive investment in a fund that makes loans in California, the Floridian may be subject to California state income tax for part or all of his income (which could go well beyond the income earned in the limited partnership). These tax rules basically raise barriers to investment pools from forming to lend to SMEs. The Obama Administration should immediately amend the tax code to make it clear that investors who are passive investors in limited partnerships are not deemed to be doing business as a result of SME lending activity. That simple tax change could immediately result in billions of new capital formation for SME lending.
Solution #2 – Amend the mutual fund rules to encourage business development companies to make senior secured SME loans
Currently, the mutual fund rules limit the amount of leverage that business development companies (“BDC”) can incur. However, these rules don’t work and actually encourage risky behavior. BDC’s are a type of mutual fund that is supposed to invest in SMEs. While the purpose of the leverage limits is to make sure that mutual fund investors aren’t exposed to the risks of high leverage, the practical effect is to make it economically unfeasible for BDCs to make low risk, and therefore lower yield, loans. Instead, BDCs have migrated to higher risk and high yield lending and investing and have performed miserably since the credit crisis began. The mutual fund rules should be immediately amended so that BDC’s are allowed to operate at higher but prudent leverage ratios (up to 4 to 1) but are restricted for that level of leverage to high quality senior secured lending (which is the lowest risk form of business lending), together with matched interest rate characteristics of assets and liabilities, i.e., floating rate assets and floating rate debt. That change will immediately result in new BDCs to be formed and push into SME lending.
It is critical to get the SME lending market restarted now. Intelligent government tax and regulatory policy could go a long way to helping stabilize our economy, and help us enter a new era of growth.