Financial institutions that participate in Small Business Administration (SBA) lending know that the program provides added opportunities to expand their lending activity, generate additional revenue and potentially meet their Community Reinvestment Act (CRA) objectives. It’s exciting when an SBA loan gets to the finish line, closes and funds.
The SBA’s guarantee covering 75% or more of the loan is a big benefit to banks; it significantly reduces the risk and the guaranteed portion doesn’t count against the bank’s legal lending limit. Banks that sell the guaranteed portion of the loan into the secondary market can book the gain on sale as additional income immediately.
But it’s important for bankers to keep in mind that just because the loan secured an SBA guarantee at the time of origination doesn’t mean that it will be there if you need it — that is, if the borrower defaults on the loan for any unfortunate reason. If your institution requests the SBA to honor the guarantee, SBA will review the loan file to make sure the bank properly closed, documented, funded and serviced the loan according to the bank’s approved credit memo and the SBA Loan Authorization. They will review it with a higher level of scrutiny when it is considered an early default, or a loan that defaults within the first 18 months. If the loan file is not documented properly or the bank failed to meet any of the requirements, SBA will issues a repair — or worse, a full denial of the guarantee. For that reason, it is important that your bank has proper procedures in place which include a pre- and post-closing review process to ensure lenders don’t miss or overlook items.
As a lender service provider that provides loan file review services for SBA lenders nationwide, I can tell you that lenders are often surprised about the types of documentation deficiencies that we uncover during a review. The deficiencies typically come from a lack of proper procedures and checklists, lack of training, misinterpretation of the program rules and requirements, or just lacking the appropriate staff to properly conduct pre- and post-closing reviews and monitor important post-close items.
The top five material deficiencies leading to a repair or denial of SBA guarantees are:
Lien and collateral deficiencies.
Ineligible or unauthorized use of proceeds.
Debt refinance eligibility or documentation deficiencies related to debt refinance.
Not properly documenting the equity injection or source of equity funds.
Not properly documenting disbursement of loan proceeds.
The SBA will also review the loan file for any post-close servicing actions that may have occurred during the life of the loan. These include loan payment deferments, changes to the maturity date, assumption requests, release or exchange of collateral, changes to the ownership structure or release of a guarantor. The SBA expects your institution follow prudent lending standards and SBA program requirements when negotiating a feasible workout structure, considering an offer in compromise or liquidating an SBA loan.
It is imperative for institutions to properly document all service actions, conduct site visits as required and submit a written liquidation plan when appropriate. This is where lenders often seem to fall short and are taken off guard when the SBA comes back with a repair or denial of the SBA guarantee because of such documentation deficiencies.
The key takeaway is that it’s always important, but especially more so now in this economic environment, to properly monitor your institution’s existing SBA portfolio. Make sure your bank has properly trained staff, well thought-out procedures and checklists for all functions and proper staffing in each area. Engaging a third party that has a high level of SBA experience to occasionally review your bank’s files and provide feedback on how well processes are working is a good practice. A highly skilled SBA reviewer can help banks identify potential deficiencies and provide recommendations for best practices that will help them keep those loan guarantees.
In the middle of 2020, while some consumers were stockpiling essentials like water and hand sanitizer, many businesses were shoring up their cash reserves. Companies across the country were scrambling to build their war chests by cutting back on expenses, drawing from lines of credit and tapping into the Small Business Administration’s massive new Paycheck Protection Program credit facility.
The prevailing wisdom at the time was that the Covid-19 pandemic was going to be a long and painful journey, and that businesses would need cash in order to remain solvent and survive. Though this was true for some firms, 2020 was a year of record growth and profitability for many others. Further, as the SBA began forgiving PPP loans in 2021, many companies experienced a financial windfall. The result for community banks, though, has been a surplus of deposits on their balance sheets that bankers are struggling to deploy.
This issue is exacerbated by a decrease in loan demand. Prior to the pandemic, community banks could generally count on loan growth keeping up with deposit growth; for many banks, deposits were historically the primary bottleneck to their loan production. At the start of 2020, deposit growth began to rapidly outpace loans. By the second quarter of 2021, loan levels were nearly stagnant compared to the same quarter last year.
Another way to think about this dynamic is through the lens of loan-to-deposit (LTD) ratios. The sector historically maintained LTDs in the mid-1980s, but has recently seen a highly unusual dip under 75%.
While these LTDs are reassuring for regulators from a safety and soundness perspective, underpinning the increased liquidity at banks, they also present a challenge. If bankers can’t deploy these deposits into interest-generating loans, what other options exist to offset their cost of funds?
The unfortunate reality for banks is that most of these new deposits came in the form of demand accounts, which require such a high degree of liquidity that they can’t be invested for any meaningful level of yield. And, if these asset and liability challenges weren’t enough, this surge in demand deposits effectively replaced a stalled demand for more desirable timed deposits.
Banks have approached these challenges from both sides of the balance sheet. On the asset side, it is not surprising that banks have been stuck parking an increasing portion of the sector’s investment assets in low-yield interest-bearing bank accounts.
On the liabilities side, community banks that are flush with cash have prudently trimmed their more expensive sources of funds, including reducing Federal Home Loan Banks short-term borrowings by 53%. This also may be partially attributable to the unusual housing market of high prices and low volumes that stemmed from the pandemic.
As the pandemic subsides and SBA origination fees become a thing of the past, shareholders will be looking for interest income to rebound, while regulators keep a close eye on risk profiles at an institutional level. Though it’s too soon to know how this will all shake out, it’s encouraging to remember that we’re largely looking at a profile of conservative community banks. For every Treasury department at a mega bank that is aggressively chasing yield, there are hundreds of community bank CEOs that are strategically addressing these challenges with their boards as rational and responsible fiduciaries.
Banks took center stage in the U.S. government’s signature pandemic aid package for small businesses, the Small Business Administration’s Paycheck Protection Program.
But into year two of the program, a nonbank has emerged as one of the top three PPP lenders. The SBA listed Itria Ventures, a subsidiary of the online commercial lending platform Biz2Credit, on Feb. 28 as the No. 3 lender in dollar value in 2021, after JPMorgan Chase & Co. and Bank of America Corp. Not only that, it was the No. 1 lender, of the top 15, in terms of total loans approved. Itria Ventures was the direct lender for 165,827 approved loans in 2021 worth $4.76 billion. Unless Congress extends the program, it runs through the end of March. The SBA updates PPP statistics every Monday so the ranking could change.
As of Feb. 28, the SBA approved $678.7 billion in low-interest PPP loans this year and last year. The potentially forgivable loans have created enormous opportunities for banks to connect with small businesses and allowed financial technology companies to make inroads into the commercial loan market.
But the significance of an obscure-sounding online marketplace lender surging past the likes of household names such as PNC Financial Services Group, M&T Bank Corp. and U.S. Bancorp for PPP dollar volume and loans wasn’t lost on Joel Pruis, a senior director for Cornerstone Advisors.
“The PPP gave a much-better opportunity to these fintech companies to get involved and it gave them the volume,’’ he says. “Prior to this, it’s been tough for them to get any type of material volume.”
During the pandemic, small businesses such as restaurants and retail shops that rely on fintech lenders fell on tough times, hurting platforms that then experienced double-digit loan delinquencies in some cases. OnDeck, a prominent online lender valued at about $1.3 billion during its initial public offering in 2014, sold to Enova International last year for about $90 million. Online direct lender Kabbage sold most of its operations for an undisclosed sum to American Express Co. last year.
Biz2Credit received some negative press last year as a merchant cash advance lender that sued some of its New York borrowers struggling during the pandemic. But the company is moving away from merchant cash advance products because the customers of those loans are small businesses struggling the most right now, such as restaurants, says Biz2Credit CEO and co-founder Rohit Arora.
Biz2Credit, which is privately owned and doesn’t disclose financial information, pivoted last year to quickly ramp up its PPP lending platform and partnerships, hoping to capitalize on what Arora anticipated would be a huge government rescue package. It generates business through referrals from the American Institute of Certified Public Accountants and its relationship with payroll provider Paychex, which has strong connections with small businesses.
It also white-labelled its PPP platform to banks and other lenders to process small business loans without the hassles of the paperwork and monitoring. Among its customers are major PPP lender Portland, Maine-based Northeast Bank, the 11th largest PPP lender in terms of dollar value as of Feb. 28.
Other technology companies seeing a surge in business due to PPP include Numerated, which provides a commercial loan platform for banks. Numerated processed nearly 300,000 PPP loans for more than 100 U.S. lenders, totaling $40 billion as of March 1. Cross River Bank, a technology-focused bank in Fort Lee, New Jersey, that works with fintech companies to offer banking services, also rose in the ranks of direct PPP lenders this year. The $11.8 billion bank ranked fifth with $2.5 billion in PPP loans.
Arora says the SBA’s constantly changing documentation, error codes and program rules were a headache for a bank but fit into Biz2Credit’s area of expertise as a technology company. It provided banks with one platform for both PPP origination and loan forgiveness, simplifying the lending process. Given the amount of work involved, Pruis says banks that chose to handle PPP lending on their own platforms have had a tough time, especially in the program’s first round of the loan program. “It was brutal,’’ he says.
Arora says Biz2Credit is perfectly suited for PPP for another reason: Most of its loans go to very small businesses, many of them sole proprietorships or operations with fewer than 20 employees.
These borrowers often don’t have a business banking relationship, pushing them into the arms of online lenders or small banks.
Small businesses have been especially hard hit by the pandemic. The Federal Reserve’s Small Business Credit Survey for 2021 found that 53% of respondents in September and October of 2020 thought their revenue for the year would be down by more than 25%. Of the 83% of firms whose revenues had not returned to normal, 30% projected they would be unlikely to survive without additional government assistance.
“This recession has been brutal for small business,’’ Arora says. “It’s a much-worse recession than the last one for small business.”
James “Chip” Mahan has a colorful past as a banker who turned himself into a tech entrepreneur. He went from a failed attempt at a hostile takeover of his hometown community bank at the age of 31 to launching the first internet bank in the 1990s, Security First Network Bank, as well as developing a successful technology company that sold internet applications to banks called SQ Corp. Later, he founded what is now one of the largest Small Business Administration lenders in the country, Live Oak Bank, and used it as a jumping off point for a technology platform that is sold to other banks, nCino, which speeds up loan processing.
He speaks here with Naomi Snyder, editor of Bank Director digital magazine on the following topics:
There were 437 bank failures in the United States between 2009 and 2012, according to the Federal Deposit Insurance Corp., most of them victims of the financial crisis and the sharpest economic downturn since the Great Depression. CalWest Bancorp was not one of them, despite experiencing some financial difficulties of its own during the crisis years, and today it faces a bright future with a successful recapitalization and reconstituted board.
As much as anything, the story of CalWest, a $136.6 million asset bank holding company based in Rancho Santa Margarita, California, is a strong vote of confidence for the potential of community banking. It is often said that small banks, especially those under $500 million and even $1 billion in assets, won’t be able to survive in a consolidating and increasingly competitive industry. The story of CalWest is about a group of professional investors who put $14 million into the bank and joined the board without compensation because they believe in the long-term future of their small community bank and are ready to roll up their sleeves and get to work.
Formed in 1999, CalWest has four branches in Southern California’s Orange County that uses three different names: South County Bank in Rancho Santa Margarita, where it has two branches, Surf City Bank in Huntington Beach and Inland Valley Bank in Redlands. President and Chief Executive Officer Glenn Gray says CalWest provides “white glove service” to a small and midsized businesses. “These are companies with probably $30 million or less in annual revenue, mostly family owned,” says Gray. “We focus on C&I lending, although we do commercial real estate [lending] as well.”
CalWest’s biggest problems during the recession were primarily bad commercial real estate loans and loans guaranteed by the Small Business Administration. The bank tried “quite a few different attempts” to either recapitalize or sell itself without success, according to Gray, although it did take approximately $5 million in Troubled Asset Relief Program (TARP) funds from the federal government in 2009. Attracted by the challenge of reviving a flagging franchise, Gray signed on as CEO in 2012, leaving a different Orange County community bank where he had been the CEO for six years. “I made the move primarily because of the opportunity to come into something that clearly needed to be fixed,” he explains. “I had a pretty good idea that it could be fixed. I like doing turnaround situations.” Gray was also drawn in by the chance to invest personally in the bank’s recovery.
The bank had entered into a consent agreement with its primary regulator, the Office of the Comptroller of the Currency, in January 2011, that among other things required it to raise its regulatory capital ratios. Gray spent the next couple of years cleaning up the loan portfolio and shrinking the bank’s balance sheet to improve its capital ratios, but wasn’t ready to raise new capital until 2015 when it retained Atlanta-based FIG Partners to manage a recapitalization of the bank. The effort ended up raising $14 million in fresh capital in December of last year from a group of private investors, although it actually had commitments for $30 million, according to Gray. The funds will be used to strengthen the company’s regulatory capital ratios, support its growth plans and retire the TARP funding. The consent order with the OCC was terminated in May.
One of those investors is Ken Karmin, chairman and CEO of Ortho Mattress Inc., a bedding retailer located in La Marada, California, and a principal in High Street Holdings, a Los Angeles-based private equity firm. Karmin had first met Gray shortly after he took over at CalWest in 2012 and they talked about Gray’s plans for the bank. “It was just too early in the process for new capital to come in,” Karmin recalls. “He had work to do to get the bank in a position to be recapitalized. But I was impressed from the moment we met. I knew he was the real deal; a very capable CEO…in control of the situation and every facet from BSA [Bank Secrecy Act] to credit quality, the investment side, lending, the relationship with the regulators. It was an amazing opportunity for investors like me to put money behind someone like Glenn, who can really do it all.”
Karmin came in as a lead investor and today serves as CalWest’s board chair. (All but two members of the previous CalWest board—Gray and Fadi Cheikha—voluntarily resigned when the decision was made to raise capital by bringing in new investors.) Other investors, who also received a board seat, were William Black, the managing partner at Consector Capital, a New York-based hedge fund; Jonathan Glaser, managing member at Los Angeles-based hedge fund JMG Capital Management; Clifford Lord, Jr., managing partner at PRG Investment and Management, a real estate investment company in Santa Monica, California; Richard Mandel, founder and president of Ramsfield Hospitality Finance, a New York-based hotel real estate investment firm; and Jeremy Zhu, a managing director at Wedbush Asset Management in Los Angeles.
Although Gray and Cheikha did stay on as directors, the current board is really a new animal. The rest, with the exception of Zhu, were people that Karmin already knew. The new CalWest board also has an awful lot of intellectual and experiential horsepower for a small community bank. “A board for a bank of this size, we have the luxury of intellectual talent basically at our finger tips,” says Karmin. The composite knowledge base of the CalWest board includes extensive experience in C&I lending, BSA, investing, commercial real estate and the capital markets. “We have the talent to make intelligent, thoughtful decisions and support management,” Karmin says.
When asked what kind of culture he would like to create on his board, Karmin mentioned a couple of things. First, he says the current directors are “willing to serve and do the work and the heavy lifting.” And from an investment perspective, they are taking the long view. Karmin says they will not receive any fees or compensation for their board service “until the bank is right where we want it, operating at the highest possible level.” Nor will the directors be taking personal loans from the bank. “If you want to borrow from our bank, this is the wrong board for you,” he says. “We’re not going to do any Reg O loans.”
More importantly, perhaps, Karmin wants a board that is very focused on performance. “We want a culture of first quintile performance,” he says. “That means that we expect our financial performance on the most important metrics to be in the first quintile of banks of our size in our geographic area.”
Given the strong private equity and investor background of all of the new directors, it’s logical to assume they will be looking for an exit strategy at some point. Karmin suggests that day, when it finally arrives, will be well off into the future. For one thing, Karmin and Gray are jazzed about the potential of the Southern California market. With about 9 percent of the country’s population, “We expect that it’s going to be one of the most important growth areas in the United States,” Gray says. “Whether the [national] economy grows 2 percent or 1 percent, it’s not going to matter to us. We’re going to be a first quintile performer under all those scenarios.”
“We have instructed Glenn to run the bank for the long haul,” Karmin says. “We were making this investment for a lot of different reasons, but that we expected to be investors and to be on the CalWest board for a long time. We have real plans to grow the bank in a controlled strategic fashion. [The directors want to] use our contacts to make new contacts, use our contacts to make new loans, use our contacts to gather new deposits. We are the kind of a board that can really help on all those metrics.”
Gray says this is the fourth bank board that he has participated on and the CalWest board is very different from all the others. “It’s a board that is very involved,” he says. “They ask good questions. They ask tough questions. If you wanted to be a CEO of a bank [that has] the old country club atmosphere, this would not be the place to be.”