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With subsidized interest rates, public loan programs abound but don't always deliver

Ronald A. Wirtz - Editor, fedgazette

Published July 1, 2000  |  July 2000 issue

Hoping to consolidate 15 claims processing sites into a centralized location, last year UnitedHealth Group of Minneapolis reportedly looked at more than a dozen cities for a facility that was expected to employ more than 300 workers.

In April 1999, the Fortune 100 company announced it would locate its new customer service center in Eau Claire, Wis., thanks in part to more than $1 million in low-interest loans from the state, Eau Claire County and Gateway Industrial Park Corp. (a quasi-public organization). The city of Eau Claire also offered two additional low-interest loans, which UnitedHealth declined.

Such a scenario, while maybe not the rule, is far from the exception as communities compete for new and expanding companies. Like Eau Claire, many communities either administer or have access to multiple public or quasi-public loan programs, using taxpayer-backed loans to close incentive deals or provide gap financing for fledgling businesses—typically at subsidized interest rates to boot.

Yet despite their growing presence, use of public money, and involvement in financial services (otherwise heavily regulated in the private sector), public or quasi-public loan programs do not appear to receive a significant amount of scrutiny.

Acknowledging a differing mission than the private loan sector, there nonetheless appears to be fragmented and inconsistent measurement of the impact and performance of public loan programs—particularly local ones—and few clear standards regarding what is or is not an acceptable rate for bad loans given a program's mission. Many examples were found where the rate of bad loans by a public loan program was five, even 10 times higher than current private sector rates.

Coming to a community near you

According to an informal survey by the Minneapolis Fed, low-interest loans were the most used of any business incentive available to local communities and distributed the most total resources (see story). For some communities, they are the go-to incentive. For example, East Grand Forks, Minn., used loans in 16 of its 18 assistance agreements made between 1995 and 1998, according to a state report.

While the number of state and federal loan offerings to business hasn't radically changed in the last decade, growth has been strong among local revolving loan fund (RLF) programs during this time. In Minnesota, the number of RLFs has gone from virtually zero in 1984 to well over 200 in 1996, according to the state's legislative auditor. In South Dakota, the number of RLFs has nearly quintupled since 1988 from 15 to more than 70, according to a recent state report.

In some ways measuring the performance of public and quasi-public loan programs can get sticky because many have social or environmental as well as economic development goals. Even when economic development is the goal, the expectations of return on investment are usually different from those of the private financial sector. To gain broader insight on the financial performance of public loan programs to business, data was requested for dozens of local programs, along with 18 state-based programs in Minnesota, the Dakotas and Wisconsin (Montana has no direct-loan programs).

According to information received, most loan programs make anywhere from zero to about 50 loans in a given year. Only a handful of programs lend more than $5 million annually, and most are at the state level. But with literally hundreds of public loan programs in the Ninth District alone, a significant amount of public money is at stake, especially given high rates of payment delinquencies and loan losses among these programs.

Financial yardstick: The good, the bad and the ugly of public loans

In the Ninth District, semi-annual reports from two dozen RLF programs in Montana, South Dakota and North Dakota (funded through grants from the federal Economic Development Administration) showed a collective portfolio of almost 450 loans worth more than $32 million. Individual portfolios ranged from a couple of loans worth little more than $100,000 to more than 140 loans worth over $7 million.

Chart: Total Value and Number of Loans Made Through State-Based Loan Programs, 1999

Combined, these programs had a 30-day past-due rate of almost 11 percent, and a write-off rate of better than 7 percent. The value of noncurrent loans and write-offs totaled $5.8 million, or 18 percent of all loan funds. One Montana program had 98 percent of its $910,000 million loan portfolio past due more than 60 days—the responsibility of a single loan.

Local loan programs also receive grant money from the federal Community Development Block Grant (CDBG) program. Montana communities have used this money to make 102 loans to businesses since 1989, according to data provided by the Montana Department of Commerce. Of that total, 13 were in foreclosure. Another 15 loans were delinquent, restructured or deferred.

If history is any pattern, the portfolio of CDBG-funded loans in Montana could see still more trouble ahead because delinquency and loss rates typically take several years to peak from when the loan is made. From 1989 to 1995, 47 CDBG-funded loans were made, and half experienced some difficulty; 12 loans have been foreclosed, and another 12 were delinquent, restructured or deferred.

Other loan programs in Montana are not faring much better. The state's microloan program provides money to intermediary nonprofit organizations, which in turn make loans to businesses, including start-ups. This program reported a cumulative write-off rate of almost 6 percent and a delinquency rate of 20 percent.

A now-defunct Montana Women's Capital Fund made 100 loans, 27 of which were partially or wholly written off (although its cumulative loss rate represented just 12 percent of funds loaned). Another 19 loans were restructured or refinanced, and at least four are currently delinquent, according to a Montana Department of Commerce source.

There are programs, however, that even the private market would envy. One of Minnesota's major loan programs—the Investment Fund—has written off only one of 120 loans made in the last five years, and just two others are delinquent.

In South Dakota's REDI Fund, only four of its 74 outstanding loans were not current, which represented less than 1 percent of the program's outstanding principal. The program's cumulative loan loss as of last year was just over 1 percent. Three loan programs in Wisconsin have made 185 loans in the last five years; there have been no write-offs and only one is currently delinquent.

But there were also ample examples of poorer-performing loan programs, at least in the financial sense. Two state loan programs in Minnesota have combined write-off and delinquency loan rates of 17 percent and 29 percent. The state's Small Business Development Loan program has 11 loans worth $41 million in its portfolio. While it has seen no write-offs to date, a $6 million loan recently became delinquent when Excelsior-Henderson—a start-up making high-end motorcycles—filed for bankruptcy.

South Dakota's Agricultural Processing and Export Program made 30 loans from 1990 to 1999, seven of which went south. In two other cases, loans were repaid but the business either moved out of the state or went out of business after paying the loan.

Since its inception in 1991 through 1998, North Dakota's Development Fund made 124 loans totaling a little over $23 million. During this time, 39 loans—one in three—have been at least partially written off, totaling $5.4 million.


While not meant as a direct comparison, it's worth noting what the private market typically achieves regarding bad loans. The strong economy has done wonders for the loan portfolios of Ninth District Banks, as both the number of noncurrent loans and loan losses have dropped significantly since 1990. The volatility of the farm economy is also very noticeable in the performance of banks in Montana, North Dakota and South Dakota.

Chart: District Commercial Banks--Loan Losses

Chart: District Commercial Banks--Noncurrent Loans


Measuring "stick-to-itiveness"

Among local loan programs, many RLFs were found in the Ninth District with no delinquent loans or loan losses for the year. But there are indications that even programs with stellar rates are sometimes playing by a different set of performance rules.

For example, a survey of 84 RLFs in South Dakota found a write-off rate of less than 2 percent. But an RLF will often bend over backward to ensure that a business succeeds. Sometimes that means restructuring the loan five or six times, according to Beth Walz, president of South Dakota Rural Enterprise, Inc., a statewide financial intermediary that raises capital and provides other nonfinancial services to public loan programs in the state.

"Here's the truth; RLFs are going to do everything they can to work with these businesses to keep them from failing," Walz said. Depending on how you view things, that can be either good or bad, she added.

"In terms of pure fiscal management, it's probably not a good idea," Walz said. "But it's marvelous for business development" because it builds a lasting, partnerlike relationship—rather than just a financial one—between the business and the lender.

"As long as there is the possibility of success and everybody is working toward that, I don't think it's bad that RLFs have the ability to be flexible" with individual borrowers, Walz said.

With six different loan programs, Bear Paw Development Corp. of Northern Montana manages one of the largest nonprivate loan portfolios in the Ninth District. It has a noncurrent loan rate of 14 percent. "A bank would pale at that rate," said Dick King, who until recently was the head of Bear Paw, having moved to a similar position at the Missoula (Mont.) Area Economic Development Corp.

King pointed out that different lending strategies demand different performance standards. Montana's microbusiness program—with its noncurrent rate of about 25 percent—targeted start-up businesses that were "high maintenance, high intensity," according to King. As a result, "you're naturally going to have less overall performance. ... The legislature authorized [the program] with precisely that in mind."

"There will always be pendulum swings" in the appropriate risk levels of a program, according to Kevin Cramer, director of the North Dakota Department of Economic Development and Finance. Individual loan programs often have to find the location of that gray line the hard way.

The Development Fund in North Dakota, for example, was very aggressive in equity investments when it started in 1991, Cramer said. Losses began piling up quickly for the fund. State lawmakers complained and made the fund much more conservative—so conservative that after several years, one lawmaker asked, "What good are you? You're not taking on enough risk," Cramer said.

Room for improvement

Most sources did, however, generally agree that performance measurement among programs often fell short, particularly among local programs. A report on RLFs in Minnesota by the Corporation For Enterprise Development (CFED) found that only about three of five could report such basic items as cumulative lending activity.

"Despite the presence of RLFs in virtually every county in Minnesota, information that documents their sources of capital, lending performance, or impact is limited and incomplete," the report stated.

Walz said she's also seen resistance to performance measurement. "Unless there is a compelling reason, a lot of them aren't keeping track," Walz said. "My response is, 'So start.'"

Much of the problem of poor performance and poor reporting stems from a lack of staffing. As many as half of all local loan programs are inadequately staffed, according to Andrea Levere, CFED vice president, who added that the current system "is devoid of incentives" to help programs do better.

"You can't blame it on practitioners," Levere said. "They have no money to do those things."

Where performance measurement is done, most fall back on job creation or retention as the main goal. The problem is that programs usually take credit for any and every job created or retained by a business that has a loan through their organization. Often the success of loan programs is "measured by ribbon cuttings" in many communities, Cramer said. "Job creation is easy in economic development."

The CFED report argued that job creation remains the best proxy for a loan fund's performance. But it also acknowledged that job creation "is notoriously difficult to quantify, given the inherent complexity of the job creation process, and the common wisdom that it is impossible to credit a single factor—even if it is as important as capital—for the creation of a new job."

"If done right, it's one [good] indicator" of performance, Levere said, and in some cases, it's the only indicator available. "If you've got a hammer, everything becomes a nail," she said.

Levere pointed out that many loan programs were designed in the 1980s when joblessness was a pressing issue. While joblessness is still an issue in most communities to some degree, larger issues of job quality and business creation (rather than job creation) were too often overlooked, she added.

The yin and yang of loan making

Greater sophistication is apparently coming to some loan programs, particularly at the state level. North Dakota, for instance, has begun to measure the wealth effect of loan programs, gauging not just new jobs and salaries, but their impact on a community's standard of living, Cramer said.

Minnesota currently tracks wage rates and the amount of private financial leverage created by the public loan, and this year will also track a loan's impact on the local property tax base, according to an official with the state Department of Trade and Economic Development.

CFED is partnering with a number of organizations to build an industrywide database to establish badly needed performance benchmarks for RLFs to measure themselves against. "You have to be serious about [performance]," Levere said. "Otherwise, how do you know what you're doing?"

As a matter of survival, performance measurement should lead RLFs to rethink the notion of providing subsidized capital, Walz said. If RLFs provide capital that the private market can't or won't supply, "it should come at a premium, not a discount," Walz said. She added that if loan programs want to grow, they will "have to find new ways to grow capital, and it won't happen [when loans are made] at zero or 1 percent."

Most of the push for better performance appears to be coming from inside the industry, rather than from the public. Indeed, given the social goals, a proactive disposition toward business and a fairly low-scrutiny profile, loan programs appear to enjoy a fair amount of support.

Even the banking community is somewhat ambivalent about public loan programs. Some banks see programs "as a way to help their business" because public loans often help leverage private loans which might not otherwise be made, according to Daryll Lund, president and CEO of Community Bankers of Wisconsin.

Bill Bond, executive vice president and CEO of the Minnesota Bankers Association, said guaranteed-loan programs are well received and frequently used by banks, and the public understands this particular role of government in the market. "Where government programs get into direct lending, that's where we start to get concerned." Individual banks might not mind government subsidized loan programs, Bond said, but the general direction of where it's going "deserves scrutiny."

"I think the key word is balance," Cramer said. "Economic development isn't about throwing money at the wall and seeing what sticks."

That means wisely protecting public resources while taking on enough risk to have a positive impact, Cramer said. Public loan programs are more diligent today, he added, conducting research like any bank would before funding a project. "But we're slightly more benevolent" on loan approvals, Cramer said. "We do end up with higher risk, and some people think that's appropriate."

Related articles:

fedgazette, April 2000
Local Economic Development, Part I


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