April 3, 2020 8:41AM

More on the Challenges of Main Street Lending

A few days ago, in response to the Fed's March 23rd announcement that it planned to help smaller businesses through a new Main Street Lending Program, I posted an essay here about the Fed's 13(b) business-lending program—a New Deal arrangement that had the same aims. Among other things, I pointed out that, thanks in part to that program's painstaking, slow, and highly selective application approval process, it ultimately made little difference to the businesses it was supposed to help. Yet until World War II came along, it still managed to lose plenty of money, by yielding a net return of minus 3 percent.

Since then, Boston Federal Reserve Bank President Eric Rosengren has told Bloomberg's Mike McKee that the Fed's new Main Street facility "is still in the design phase," and that it won't be up-and-running until mid-April. "It's a complicated facility to appropriately scope," he said; and the Fed "needs to make sure that banks and other organizations understand what the nature of the facility is." The Fed seems determined to avoid the fate of the SBA's complementary, $350-billion emergency lending program, which is set to launch tomorrow. According to today's Wall Street Journal, the fact that that program's details have yet to be ironed-out

is complicating efforts by lenders to gear up for what is expected to be an onslaught of prospective borrowers at the end of this week. Among what lenders say are the unanswered questions are how much due diligence of borrowers is required and whether they will be able to sell these loans to create liquidity.

In this follow-up to my last post, I review some of the logistical challenges the Fed encountered in administering its 13(b) loans. Doing so may help readers to understand some of the issues with which Fed officials are now grappling. And who knows? Perhaps those officials themselves will draw some lessons from it.

Naughty or Nice?

Thanks to Robert Rosa, who was then Research Chief of the Federal Reserve Bank of New York, we have a pretty good picture of the challenges Fed officials faced when they first ventured into the business of lending to small and medium-sized businesses. Rosa spent over a year carefully studying "the dossiers of some 250 of the small concerns" that applied to the New York Fed for 13(b) loans during the Great Depression. He later published his findings in the Journal of Finance.

Those findings mainly concerned the challenges the New York Fed faced, first in evaluating applications it received, and then in managing those loans it chose to grant. To make a long story short, Fed officials and staff discovered the hard way that lending to ordinary businesses, and to smaller ones especially, posed all sorts of problems they'd never had to confront in supplying credit to banks.

Perhaps the biggest of those problems was that, despite the depression, many of the firms that applied to the Fed for credit weren't just victims of economic circumstances beyond their control. Instead the applications Rosa reviewed revealed a "complex set of small business problems which are too often waved aside when we think of increased credit availability as the panacea to small business ills." Rather than being the ultimate cause of many applicants' troubles, the depression only served to expose their more deep-seated weaknesses.

While additional borrowed money often seemed to be the only way out for most of these concerns, the original causes of their distress were not financial in most cases. They had instead, as a rule, worked themselves out of satisfactory credit lines by mistakes or misfortunes in managerial judgment.

The trouble wasn't simply that many businesses weren't worthy of the Fed's support. It was that of determining which ones were and which ones weren't. "Even if a concern had none of the difficulties I have just described," Rosa observed, "it would still be a long step further for the loan officer to verify that to his own satisfaction." Many smaller firms couldn't themselves furnish the Fed with detailed reports of the sort that give a sense of their condition and prospects. "These circumstances," Rosa says, made "the job of credit investigation, and the final decision to grant a loan, exceedingly difficult." For the most part the Fed could only satisfy itself of firms' creditworthiness through investigations it undertook itself. Beyond that it had to retain staff who "could go in and set up bookkeeping systems, establish accounting controls, appraise and recommend changes in plant condition, lay-out, quality of machinery and inventory, and so on."

All of this didn't come cheap. On the contrary: Rosa found the expenses connected to the New York Fed's 13(b) lending "staggering":

without any allocation of such fixed costs as office space, light, and heat, the combined expenses of the New York Bank (before losses on granted loans) averaged about $625 per formal loan application. Of this amount, at least $400 can be attributed to the credit investigation process, although that part of the expense ran much higher in some individual cases. Costs ran this high because of the generous use of the industrial engineer, and also because the Bank had no backlog of old names to draw on-all applicants for 13b credit were new names to the Reserve Bank.

A labor cost of $625 in 1935 was equivalent to a cost of almost $40,000 today.

Despite the lengths they went to assess applicants' creditworthiness, Fed staff often found themselves flying blind, especially because they lacked information about the general state of a given trade or the industry. In such cases they naturally proceeded cautiously. But in some others, and especially when many jobs were at stake, they gambled on companies they considered likely to fail, hoping that the often doubtful collateral they asked for would limit their losses.

Such cases were exceptional, however. On the whole, Rosa writes, the "mundane factors of investigation cost and the need for operating advice seem to me the greatest obstacles in extending adequate loan credits to small business."

In For a Penny…

Nor was the Reserve Bank's hardest work behind it once it chose which loans to make. Instead, it "found right away that actual receipt of the funds did not solve very many of the problems" of most firms it lent to. To begin with, it ended up having to extend or renew a third of the loans it made. But that

was only a part of the story. Once in, the Bank ordinarily assumed an affirmative responsibility, providing assistance wherever the borrower would accept it. …Wholly apart from any altruistic motives, the Bank was really forced to act to protect its investment.

Such assistance could also consume many staff hours. In the case of one three-year loan, Rosa reports, the Bank's industrial engineer had to make twenty-seven different trips to the firm, lasting from a few days to several weeks, in order to try and help it stay afloat. Yet "the company still went bankrupt, and the Fed booked a sizeable loss."

Despite all the challenges he encountered, Rosa resists the conclusion that the results of the Fed's 13(b) lending "were not worth the effort." However, he does offer a warning that it would be unwise for Fed officials today to ignore, to wit: "that credit granting to smaller businesses is likely to involve a great deal more after the funds are advanced than simply checking off repayments. At least for the cases I have seen, credit alone would do very little. Continued managerial advice and assistance is required."

Whether the Fed is prepared today, not just to begin lending money to Main Street, but to offer it—or to have its partner banks offer it—"continued managerial advice," remains to be seen. I'm afraid I rather doubt it; but I very much hope that I'm wrong.

[Cross-posted from Alt-M.org]