Are Predatory Business Loans the Next Credit Crisis?
Unlike mortgage and payday lenders, the growing number of institutions that offer quick cash to small businesses are still largely unregulated. Chicago is the first trying to change that.
Los Angeles restaurateur Jorge Rodriguez Assereto doesn’t need much sleep. He gets about five hours per night and the rest of his time is devoted to running Los Balcones, a successful Peruvian restaurant he opened in Hollywood in 2004 and recently shepherded through an expansion. The remodel was a major investment. Assereto spent more than $130,000 over two years just renting the vacant space next to him while he tried to find financing for his expansion. He even switched banks in an attempt to get a loan. It didn’t work.
When he finally got the money, he hired a local design firm to turn the interior into a hip and rustic open space. He added liquor to the bar, hired two experienced bartenders and sent them to Peru to devise a new cocktail menu. But as the planned reopening date neared in early 2014, Assereto was running out of cash. He needed about $30,000 to stock his new bar and to pay for other supplies to fill out his larger space. Rejected yet again by his primary bank, he began to get desperate. Sifting through his junk mail, he pulled out one of the many solicitations he’d received from alternative lending companies. He made a few calls. The annual interest rates he was quoted were painfully high -- as high as 60 percent -- but Assereto saw it as his only choice.
With the high-interest six-month loan he received, Assereto wound up paying the online lender $6,000 per month on top of his existing obligations. That turned out to be a major financial strain, and Assereto had no flexibility with the terms of the loan. But he actually considers himself lucky: The loan helped him expand when the banks frustratingly wouldn’t. Still, he knows plenty of other restaurateurs who have had to take on this kind of debt just to make ends meet. For them, these high-interest loans quickly become an insurmountable burden. “They think, ‘If I can just survive a few months, I’ll be OK,’” Assereto says. “And that never happens.”
Assereto and his fellow restaurateurs are part of a growing number of small business owners who have turned to alternative lenders to help them stay afloat. These lenders -- mostly online and almost completely unregulated -- may offer loans at exorbitantly high interest rates. But many small businesses, unable to get a loan from a traditional bank, say they have no other option.
If that all sounds a little familiar, that’s because it is. What’s happening right now with small business loans seems to be following a familiar pattern of lenders selling debt to borrowers who can’t afford it. A decade ago, unchecked mortgage lenders sold homeownership on unrealistic terms to people who didn’t qualify for traditional bank loans, contributing to the collapse of the housing market. Similarly, predatory payday lenders have made big business out of offering quick cash for consumers in exchange for triple-digit interest rates and myriad hidden fees. Both the mortgage lenders and payday loan outfits have attracted plenty of attention from government regulators, who have sought to put in place tougher protections to shield individual consumers against predatory lending practices.
But the issue of predatory small business loans is different. It’s only just now starting to show up on some regulators’ radar, and few places have started any conversation about how to get in front of the problem. As it stands today, small business entrepreneurs have essentially no protections against predatory lending. And that has many experts worried that these loans could represent a new looming crisis. “It’s not so long ago that this happened in the housing market,” says Mary Fran Riley, the vice president of external affairs for the Chicago office of Accion, a small business lender that is seeking greater regulation of the industry. “I was working in housing during the mortgage crisis, and this feels the same in the lack of transparency.”
Following the recession, credit dried up for just about everybody. As the economy has recovered, access to credit has improved for many -- but not for small business owners. According to the Federal Deposit Insurance Corp., bank commercial loans of $1 million and less have declined each year since the financial crisis and are still 20 percent below pre-recession levels. Meanwhile, loans of more than $1 million, which are more profitable for banks than smaller loans, have recovered completely.
In the absence of bank lending, alternative sources of credit have grown. According to one estimate, alternative small business finance is doubling each year and is now estimated to total nearly $25 billion per year in loans.
To be sure, many of these lenders are well-intentioned. Nonprofit microfinance organizations, often organized as a community development financial institution (CDFI), tend to act like community bankers and often focus their efforts on those without access to reasonable credit or who don’t have a credit history. These organizations generally make loan terms several years long with interest payments between 10 and 20 percent.
But it’s the bad actors that have many people worried. These companies are found online and often package their product as a cash advance, neatly avoiding the legal definition of a loan. Much like payday lending, the lender pays itself back via automatic withdrawals from the borrower’s bank account. Fees are carefully hidden and interest rates are often disguised. For instance, a lender may quote a 10 percent interest rate, but that may actually be a monthly rate -- meaning the actual annual percentage rate is 120 percent.
As with payday loans for consumers, businesses can easily get caught in a cycle of mounting debt with fewer and fewer resources to pay it off. A recent report by the microlender Opportunity Fund highlighted a typical example: A Southern California bakery had taken loans out from three alternative lenders and a merchant cash advance company. The bakery was making more than $600 a day in debt payments -- more than a quarter of its daily cash flow. Unable to keep it up, the bakery was ultimately shuttered.
Instances like that are what prompted microlender Accion to begin pushing for new regulations. Over the last two years, the group’s Chicago office has been fielding more and more calls from business owners buried in multiple high-interest loans and looking for an escape. Seeking a solution, Accion turned to the city’s Department of Business Affairs and Consumer Protection, which had been a reliable partner in the past on predatory lending issues. But when Commissioner Maria Guerra Lapacek started looking into what regulatory solutions were available, she hit a wall. “I was a little surprised that charging a business 100 percent annual percentage rate is perfectly legal,” she says. “There’s not a lot of regulation. There is really no ceiling when you’re talking about interest rates for business loans.”
Regulating bad actors is tricky. As governments have learned in targeting payday lenders, every new regulation seems to create a new loophole. If a state, say, imposes a cap on the interest rates that payday lenders can charge, the loan company will simply set up shop in a different state without a cap and then market online to everyone. Lenders have also become adept at evolving to skirt new laws. When Illinois, for example, passed legislation limiting payday loans, the state defined payday lending as a short-term loan of 120 days or fewer. Once the law was in place, companies simply began issuing loans for 121 days.
But there are two areas where observers say public policy changes could make a difference: education and transparency. Chicago is targeting both in what is possibly the first major effort by a government to crack down on predatory lending to small business owners. Typically, Lapacek says, the city likes to look to its peers for ideas on regulation. But finding no examples, Chicago set out to craft its own rules. Working with local policy experts, the city is drafting regulations for business-to-business products that could require these enterprises to meet certain transparency standards, such as disclosing an annual interest rate and any fees. The city also launched an awareness campaign at the beginning of this year that features ads on city buses encouraging business owners to call the 311 line for help on finding financing. “They shouldn’t feel like they’re on their own,” Lapacek says. “The lending does seem predatory. If we can protect consumers, we should be able to protect small business owners.”
Even if Chicago succeeds in creating regulations targeting these small business lenders, no one is saying it will stamp out predatory lending in the market entirely. But the hope from Accion and others is that the effort will help Chicago’s small business owners sniff out offers that look too good to be true. Chicago could prove to be a model for other cities, but at the very least, a major city taking action might help others wake up to the problem. “We’ve gone from bank-led lending to the Wild West of new lenders who are working in an almost entirely unregulated environment,” says Mark Pinsky, CEO and president of the Opportunity Finance Network, a network of CDFIs. “And right now, not enough people know about it.”
One reason that predatory business lending has flown under the radar may be that, so far, it’s a problem that has primarily affected minority business owners. Spencer Cowan, vice president of the nonprofit fair lending advocate Woodstock Institute, has studied minority business loan rates in the Chicago region. He’s found that businesses in majority-minority Census tracts were far less likely to receive a bank loan than businesses in majority-white tracts. It’s a pattern that Cowan suspects is being replicated across the country. “This environment hasn’t produced the widespread business failures that get national attention,” he says. “When the foreclosure crisis started spilling over into the suburbs, that’s when the mainstream public became aware of it. That’s when it got attention.”
It’s impossible to say how many minority-owned businesses are denied loans every year. A map compiled by the National Community Reinvestment Coalition last year, using data from 2012, shows vast “lending deserts” where zero loans were issued to minority business owners for the entire year. The deserts were particularly prevalent in the Midwest and South. But what the map doesn’t show -- and can’t -- is how many minority business owners applied for a loan and were turned down. Unlike with mortgages, federal agencies don’t require banks to report business loans they rejected or to report any data on the rejected loan applicants.
Just because a minority-owned business doesn’t receive a loan from a bank doesn’t necessarily mean it will turn to alternative lenders to get the money. But it’s a safe bet, says Cowan. “This is an area, like payday lending, that could cause serious problems. I think it merits a policy response.”
The entire situation is likely to get worse before it gets better. In some ways, predatory lending to small businesses is in its infancy. Loan gouging is still widely thought of as a problem that only affects consumers, and federal regulations for better loan reporting by banks could be years down the road. But states and localities should be addressing the issue now, says Pinsky. “We see this coming,” he says. “Hopefully we’re far enough off that we can do something now. But it is coming and there’s no stopping it.”