SBA 7(a) loan defaults are time consuming and drastically impact the profitability of a lender’s SBA loan program. In this article, we will identify potential areas for repair or denial and discuss best practices to mitigate these areas of potential loss.
Before diving directly into the top reasons for repair or denial, let’s take a closer look at the latest SBA 7(a) loan default statistics. For the first time in seven years, “purchase rates” – the total dollar amount of principal and interest purchased by the SBA on a guaranteed default loan – experienced an increase in year-over-year volume, increasing 12.3% from $588 million in FY2016, to more than $660 million in FY2017.
As default purchase balances are projected to continue to increase due in part to seven consecutive years of increased year-over-year new loan originations, understanding the 6 most common actions which cause repairs or denials during the SBA’s assessment of the lender’s guaranty purchase package will be critical. Avoiding these scenarios will not only safeguard each SBA guaranty but will also protect the sustainability of a lender’s 7(a) program as well.
Understanding Repair and Denial
In practical terms, a “repair” should be viewed as a fine or penalty, reducing the SBA guaranty percentage, issued by the SBA during the purchase review process if the SBA determines the lender was imprudent. A “denial” – more severe than a repair – is when the SBA determines a lender’s action was severe enough to negate the guaranty in its entirety.
Fully understanding the top reasons for repair or denial and proactively improving controls to hedge against the risks which cause these penalties is critical.
There are 6 key areas where lenders’ actions most commonly cause repairs or denials during the SBA’s assessment of the lender’s guaranty purchase package.
Reviewing the Top 6 Reasons for Repair or Denial
SBA’s policy for guaranty purchases is to reach a fair decision based on a thorough review of the lender’s request and all relevant documentation. Should the SBA determine a lender was imprudent during any process of the loan life-cycle, they may penalize the Lender with a repair or denial. The actions typically triggering SBA repairs or denials can be grouped into the below major areas:
1. SBA Loan Eligibility – Denial
The most common reason for SBA 7(a) loan denial is SBA Loan Eligibility. The key to mitigating eligibility concerns within the 7(a) program is to identify potential risks during a lender’s underwriting and pre-screen process. The most common eligibility concerns for 7(a) loans are:
- Ineligible Franchise or Industry
- Ineligible Loan Purposes/Structure (e.g. SBA size standards, Ownership verification)
- Ineligible Loan Recipient (e.g. Conflict of interest with lender associate, failure to verify CAIVRS
2. Early Defaults – Denial
The SBA reserves the right to deny the SBA loan guaranty in full if it determines that a SBA 7(a) loan was imprudently underwritten and the SBA loan defaults within the first eighteen (18) months after the final disbursement. Ensuring proper documentation is in place prior to a loan closing in order to clearly show that the loan followed proper SBA eligibility screening and closing protocol is key to mitigating early default denials. Some of the most common causes of early default denial are:
- Improperly documenting verification of borrower financial information with the IRS
- Improperly documenting all equity injection requirements (including source) set forth in the applicable SBA SOP
- Lender’s credit memo does not directly reflect the final loan structure authorized
3. Unauthorized Use of Proceeds – Repair or Denial
The SBA reserves the right to repair or deny the SBA loan guaranty if it determines that the borrower improperly used 7(a) loan proceeds or if the lender fails to properly document the use of proceeds at disbursement. Some of the most common areas which cause use of proceed repairs are:
- Lender refinancing its own non-SBA loan with PLP loan proceeds (preference)
- Lender disbursing proceeds outside of agreed limits per the Authorization
- Multi-draw and construction related uses of funds not properly documented per applicable SOP 50 10 protocol through final disbursement
4. Lien or Collateral Issues – Repair
Improperly securing collateral continues to be one of the top reasons for repairs when an SBA loan defaults. Lenders need to ensure proper pre/post-funding audits are performed to mitigate the most common types of collateral repairs:
- Failure to obtain required lien position per the Authorization
- Failure to properly perfect a security interest
- Failure to fully collateralize loan at origination when additional collateral was available
5. Undocumented Servicing Actions – Repair
One of the primary items reviewed by the SBA when an SBA loan default is the Authorization to ensure that any changes which occurred during the life of the loan prior to default were accurately documented in a servicing action “memo” and reflected on the transcript. Some of the most common types of undocumented servicing actions which cause SBA repairs during a loan default are:
- Forgetting to renew or improperly renewing lien positions when required
- Releasing or subordinating collateral without business justification
- Allowing hazard insurance to lapse on collateral and collateral is subsequently destroyed
- Allowing life insurance to expire and principal subsequently dies
- Releasing a personal guaranty without SBA consent
6. Liquidation Deficiencies – Repair
When SBA loans default and liquidation is required, the lender is required to liquidate the loan per criteria set forth in the SOP 50 57 2 in order to maximize recovery of the loan. The lender must always remember that it’s liquidating the loan on behalf of both itself and the SBA. Having a knowledgeable SBA staff on-hand and well-developed SBA specific liquidation controls is crucial to mitigating the top reasons for SBA liquidation repairs such as:
- Failure to conduct site visit within sixty (60) days of payment default or fifteen (15) days of a material adverse change
- Improperly liquidating collateral, resulting in a missed recovery
- Misapplication of recoveries during liquidation
- Releasing guarantors without SBA approval (typically a denial)
The largest asset to a lender during an SBA loan default is often the guaranty. Given that default purchase balances are projected to continue to increase, understanding the top 6 reasons for repair or denial and how to implement the necessary controls to mitigate the risks in each stage of the loan life-cycle is critical for any lender participating in the SBA 7(a) Program.
About Windsor Advantage, LLC
Windsor Advantage provides banks and credit unions with a comprehensive outsourced SBA 7(a) and USDA lending platform.
Since 2010, Windsor has processed more than $1.7 billion in government guaranteed loans and currently services a portfolio in excess of $1.0 billion for more than 80 lenders nationwide. With over 150 years of collective government guaranteed lending experience, cutting-edge technology and rigid controls, Windsor Advantage is uniquely qualified to assist clients with implementing a thoughtful and profitable lending initiative.
Windsor Advantage has a team of 30 professionals with offices in Chicago, Illinois; Indianapolis, Indiana; and Charleston, South Carolina. For more information, please contact Andrew Sheaffer at (312) 248-8530.
About the Author: As Chief Operating Officer of Windsor, Mike Breckheimer is responsible for daily operations in processing, servicing and risk management. Prior to Windsor, Mike was a senior management consultant in the KPMG financial institutions group. He has extensive experience working with diversified financial firms to implement efficiencies and can be reached at (312) 763-3219.