To: Dr. Susan Soroka
October 9 2014
Consumer and Lender Perspective
Dr. Susan Soroka
Undergraduate Finance Major
Entrepreneurs looking to create a smallbusiness can find a vast amount of loans and services to fit theirselected needs. Banks will typically give a small business loan to acompany if the owner can show how he can cover the loan in nearfuture. Banks look for three major things in particular, capacity,collateral, and conditions when lending. Capacity refers to thefinancial capability of the business to earn interests after loaninvestment and repay the initial loan amount plus the interest.Collateral, on the other hand, refers to an asset places in custodyof the financial institution offering the loan, which they gainpossession of in case the loaned business fails to repay the loan.Finally, conditions refer to the terms of the loan as the interestrate and the repayment method and time allowed. If a company canproduce these, the lender and the recipient can start a businessrelationship. Leadership is key to any business. It is especiallycrucial in funds management and budgeting for the coming financialyear. Leadership affects the banking industry in a differentperspective. On this note, the management in the banking industry isa key focus. Management in the banking industry affects thepercentage of the banks’ reserves that can be lent out to potentialentrepreneurs, as well as the prevailing lending rates (Cocheo2014). We will go into detail in thispaper about how not only leadership through the banks and financialregulators can affect small businesses, but also, how home mortgagespolicies can be compared to banks and small businesses.
According to the banking industry, it is commonfor banks to incline to lend out to businesses as compared topersonal loans. Banks offer loans on three bases capacity,collateral and conditions. To analyze a business’s capacity,banking institutions match the business’s debts against its assetsand the trend in cash flow in the business account. In such a case,businesses that possess a deficit in the difference between the twodoes not meet loan qualifications (Hsin-Yu2014).
Banks cannot give out loans without a collateral asset. A collateralasset is one that is of close value to the loan amount. The bankholds the asset in case a business defaults payment. When businessesapproach banks for loans, they present the bank with their desiredconditions for the loan while, at the same time, the bank forwardsits own till the two parties reach an agreement.
Small Business Loans vs. Mortgages
Small businesses are an interesting market forbig banks. Traditionally, small businesses have been viewed as arisky market to get into for large banks, particularly because largeloans for large companies are a safer way to make money. Author andresearcher for the ABA banking journal, Lisa Valentine, says, “Theopportunity may be there, but many banks just don’t know how to winat small business banking. That’s the consensus of many of thosecontacted for this article” (Burton2014).
In her article, she points out how banking industries are graduallyevolving to meet the needs of small businesses. She points out thatnot only are banks beginning to structure their banks using advancedanalytical systems which can help predict if a small business willmeet the requirements of the loans distributed. “The key is toselect a technology based on the bank’s small business strategy.Because many small business loans more closely resemble personalloans than commercial loans, a bank looking to increase its lendingto sole proprietors and limited liability companies likely needs anunderwriting tool designed to analyze the creditworthiness of theowner rather than one designed to analyze company financialstatements” (Valentine 2014). With the right composition ofcorporate structure and financial analysis tools, banks can lend tosmall businesses successfully.
The small businesses with small loans havebecome something that banks want to invest in more. Nemeroff (2014),writer for the “American Banker” writes, “The financial healthof small businesses has improved over the last 12 months thuscreating a demand for more reasonably priced, longer-term productswhich institutional players can provide," Arora said. TheBiz2Credit study analyzed 1,000 loan requests of $25,000 to $3million from businesses opened at least two years that have anaverage credit score above 680. (2014). We see an upward trend withlending, for good reason.
Financial Crisis of 2008, and how it may be recurrent
I found an interesting article, pointing towhat caused the 2008 financial crisis, talking about the benefits ofan adjustable rate mortgage. “His new flavor of adjustable- ratemortgage is hot: Almost half of Atlanta-based Home Bank Mortgage`sloans are interest only. Lending giant Washington Mutual says thatits "Option ARM" is now its second-most popular loan. Itlocks in a low payment based on today`s rates, but if rates rise, thepayment might not even cover interest, and those who don`t pay morewill be adding to their debt.” (Clark 2003). As we now well know,adjustable rate mortgages caused the financial burden we had in 2008,since many of the people who took the loans had no way of paying themback, causing a meltdown particularly for home owners. Clark wasable to predict this outcome here
But that handoff of interest-rate risk costsborrowers. Although many of the loans have caps on how many paymentscan rise, borrowers who stretch now to make payments could be in fora nasty surprise if rates rise. Borrowers who would pay $916 a monthin interest for a $200,000 loan will pay $1,185 if rates revert totheir average of the past ten years. And most of the loans requireborrowers to start paying principal down after five or 10 years,adding hundreds of dollars to the monthly tab. If home prices riseslowly, or even fall, homeowners could be left with little or noequity (Clark 2003).
Essentially, smart investors saw that there wasa problem brewing for the economy. The banks were gambling on theability for homeowners to pay off loans while simultaneously makinglarge corporate profits. Projected earnings and CEOs wanting a biggersalary were partly to blame. People not taking responsibility fortheir finances were to blame as well. Clark points out (2003) thatmany people would take an ARM and spend the extra money on thingssuch as “vacations” or “furniture”. In reality, this “moneyout of thin air” rarely happens. When they should have been payingmoney out of principal instead of the interest first ARM loans, thepeople spent their money on novelties. The loans seemed tailored forrisk takers wanted to invest the extra money themselves and beat thebank`s interest rates, or for someone who wanted to move sooner.However, more often than not, the extra money from ARMs was usedirresponsibly (Curtis 2014).
The Aftermath of 2008, is History repeating?
To many people`s ignorance, ARMs, in fact, do exist. “The profileof ARM borrowers has changed in the wake of the crisis. Today theyhave an average FICO credit score of about 771, says Cecala, betterthan the 755 average score for fixed-rate borrowers. Regulationstemming from the 2010 Dodd-Frank Act includes the "ability torepay" measure that requires lenders to make sure fixed-rate andARM borrowers can make their payments. However, since the rules forARMs usually allow borrowers to qualify on the loan`s initial rate,some may not be able to afford their mortgages after the fixed periodends. “Howley, (2013). We see from here that ARMS are, in fact,coming back, although they are a bit more responsible, indicated bythe higher credit scores.
If we were to be a bit more cynical, we would see that history is infact, repeating itself.
With fixed rates projected to gain throughthe next two years, ARMs will underpin about one-tenth of the market,according to Freddie Mac. That will enable some people to buy abigger home with an ARM than they would have been able to buy with afixed loan. A 1 percent change in fixed rates means home shoppers whoin June qualified for a $400,000 house may now have to look atproperties priced at about $350,000. ARMs may enable some people tobuy a larger home because their interest rate will usually be atleast one percentage point lower than a fixed-rate loan. Rates onARMs can rise dramatically, as much as 5 percent in the first yearafter the fixed term expires. "When people want a bigger housefor their families, and they`re sitting across from loan officers insuits assuring them an adjustable is a financially sound choice, it`snot surprising a lot of people believe it," says Jay Westbrook,a law professor at the University of Texas (Howley 2013).
It is key in understanding that in fact,history can repeat itself. People are yet again spending money theydo have, on mortgages that they cannot afford. In the wake of the2008 financial crisis, the banks will need to help hold the laymen`shands when it comes to ARM since it seems the people cannot do it forthemselves (STREETER 2014).
Small Business Administration (SBA)
Small business administration is an associationthat runs through time from 1953 to provide small businesses withstartup capital loans. The organization works through banks and otherlending institutions to give an opportunity to new entrepreneurs inthe market through different lending programs. Some of these includeLoan Guarantee Program, 504 Fixed Asset Financing Program, MicroloanProgram, and Disaster Loan Program. These programs pitch into thegovernment efforts to create employment funds to the youngergenerations with entrepreneurial ideas, but with no funds. Similarly,these lending programs are similar to government agencies lend outsin the sense that they have a low interest on return. Additionally,only people with small businesses or business proposals are legiblefor application. The difference between the SBA loan programs andgovernment lend outs is that government lend outs have a fixed budgetwhile SBA loan programs depend on the number of business applicationsin need of a loan (VALENTINE2014).
For a qualification for such loans, businesses need to provide anannual strategic plan for profit and at the same time, it should be aviable business venture. The businesses must also show their capacityto repay the loan by placing the business under unlimited liability,which, may act as a collateral in other contexts.
Laws Guiding Mortgages and Small Businesses
Many laws have changed in recent history in order to spur both smallbusiness loans and home mortgage. “To help stimulate the growth ofa secondary market for conventional small business loans, Congresspassed the Riegle Community Development and Regulatory ImprovementAct in 1994. The law was intended to reduce the regulatory barriersto the securitization of conventional small business loans”Kormendi/Gardner Partners (2003). Deregulation is a common theme whentalking about small business loans.
However, in the past, businesses were predicted to rise eventually,due to credit score being major part of applying for a small loan ormortgage. “Several factors have hindered the emergence of asecondary market during the past decade. The two most important onesare the abundant supply of liquidity in the banking sector during the1990s, which has reduced the need for extra liquidity from the publicmarkets, and the lack of standardized loan underwriting practices,which has made it difficult to characterize the quality of thesecurities. This second condition may be changing, however, becauseof two recent trends in the banking industry—the emergence of giantinterstate bank holding companies and the increased use of creditscoring as the basis for loan approvals.”(Kormendi/Gardner Partners(2003). This change has certainly gone through since the 1990s andpossibly foreshadowed an incoming crisis.
We see that history may repeat itself since both banks and people areacting irresponsibly. On the plus side, we see that a small businesseconomy is doing very well, as legislation fights to deregulate.However, on the other side of the spectrum, we see that the banks have failed customers when giving out ARM to people who had no meansof paying them back, and lacked the intelligence and knowledge tounderstand their situation. What we can get from this study, is thatsomehow, the mortgage industry needs to take lessons from the smallbusiness loan industry: there needs to be better credit score checks,and more regulation, to prevent another market failure.
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