Office of Inspector General - Reports - ROM 10-19 - Material Deficiencies Identified in Early-Defaulted and Early-Problem Recovery Act Loans

Inspector General

ROM 10-19 - Material Deficiencies Identified in Early-Defaulted and Early-Problem Recovery Act Loans

Date Issued: Friday, September 24, 2010

Report Number: ROM 10-19

To: Eric R. Zamikow
Associate Administrator for Capital Access /s/ Original Signed

From: Debra S. Ritt
Assistant Inspector General for Auditing

Subject: Report on Material Deficiencies Identified in Early-Defaulted and Early-Problem Recovery Act Loans ROM 10-19This report presents the results of our audit of early-defaulted and early-problem 7(a) loans disbursed pursuant to the American Recovery and Reinvestment Act of 2009 (Recovery Act). Early-defaulted loans are those loans that default or are made to businesses that fail within 18 months of final disbursement. Early problem loans are those loans that experience payment problems prior to final disbursement or within the first 18 months after final disbursement.(1) The Recovery Act provided the Small Business Administration (SBA) with $730 million to expand the Agency's lending and investment programs and create new programs to stimulate lending to small businesses. Under the provisions of the Recovery Act, SBA temporarily eliminated the upfront guaranty fees and increased the maximum guaranty percentage to 90 percent for most 7(a) loans.(2)

The audit objectives were to determine (1) whether early-defaulted or earlyproblem 7(a) Recovery Act loans were originated and closed in accordance with SBA's rules and regulations and commercially prudent lending standards, and (2) if not, whether the noncompliance with SBA requirements or commercially prudent lending standards led to the loan problem, default, or unnecessary losses.

To answer these objectives, we judgmentally selected 39 loans for review from the 65 Recovery Act loans that had been purchased by SBA or placed in liquidation status by lenders as of December 31, 2009. Some of these loans defaulted within 3 months of disbursement. See Appendix I for further details on our sampling methodology and Appendix II for a list of the sampled loans.

We reviewed SBA and lender loan files and interviewed SBA and lender officials as necessary. For all loans examined, we also reviewed information contained in SBA's Loan Accounting System, Guaranty Purchase Tracking System, and the Centralized Loan Chron System. We conducted our audit from January 2010 to May 2010, in accordance with Government Auditing Standards prescribed by the Comptroller General of the United States.

BACKGROUND

SBA is authorized under Section 7(a) of the Small Business Act to provide financial assistance to small businesses in the form of Government-guaranteed loans. SBA 7(a) loans are made by participating lenders under an agreement to originate, service, and liquidate loans in accordance with SBA's rules and regulations. SBA is released from liability on the guaranty, in whole or in part, if the lender fails to comply materially with any of the provisions of the regulations or the loan authorization; or does not make, close, service or liquidate the loan in a prudent manner.

As of December 31, 2009,27 Recovery Act loans had been purchased by SBA and 38 others had been transferred to liquidation status by lenders, indicating early loan default or early payment problems. These 65 loans were approved for nearly $8.2 million and represent 0.2 percent of the 34,040 Recovery Act loans made. As of June 30, 2010, there were a total of 484 early-defaulted or early-problem Recovery Act loans approved for $69,205,600.

Previous Office of Inspector General (OIG) audits identified material lender noncompliance in originating, closing, and servicing early-defaulted loans in accordance with SBA requirements and prudent lending practices, which resulted in an increased risk of loss to SBA.(3) Furthermore, a recent OIG audit of Recovery Act loans also identified material origination and closing deficiencies.(4)

RESULTS IN BRIEF

The audit identified material deficiencies in 32, or 82 percent, of the 39 early defaulted or early-problem Recovery Act loans reviewed, which resulted in the disbursement of approximately $5 million to borrowers who could not repay or were ineligible for the loans. Twenty of these loans were made by two lenders that used credit scoring matrices that did not comply with SBA requirements. One of the lenders no longer makes SBA loans, while the other lender, who is still active, was responsible for 18 of the 20 loans. Another 12 loans had repayment ability, equity injection, and/or eligibility deficiencies. We believe that these material deficiencies caused or contributed to the early loan defaults or loan problems. Issuance of these loans that should not have been made prevented other eligible borrowers from receiving Recovery Act loans. As of June 11, 2010, SBA purchased its guaranteed share on 25 of the 32 loans resulting in an SBA loss of $375,259.

In addition to the material deficiencies identified above, our audit also determined that lenders made disbursements without the (1) required immigration certifications, (2) restricted use certifications, and/or (3) Forms 159, Fee Disclosure Form and Compensation Agreement, on 28 Recovery Act loans, including 24 of the loans identified above with material deficiencies. Eleven loans with missing immigration certifications were purchased at the higher 90-percent Recovery Act guaranty amount, resulting in a $7,025 loss to SBA. While 10 of these loans also had material deficiencies for which the SBA loss is already being questioned, for one loan, the only deficiency identified was a missing immigration certification. As a result, SBA should obtain the certification for this loan or recover $3,248 from the lender. Finally, our audit identified suspicious activity in 10 loans, which have been referred to our Investigations Division for further review.

In order to address the loan deficiencies, we recommended that SBA: (1) reexamine the credit scoring matrix used by 1 lender that made 18 of the 32 loans with material deficiencies to ensure it complies with SBA requirements; (2) implement a process for providing feedback to SBA employees and lenders when deficiencies are identified; (3) require the lenders to bring the 25 purchased loans with material deficiencies into compliance or recover the $375,259 in SBA guaranties paid; (4) obtain the certification for the loan missing only an immigration certification, or recover $3,248; and (5) flag the other loans that have not yet been purchased to ensure the loan deficiencies are properly addressed at the time of purchase review.

RESULTS

Material Noncompliance May Have Caused or Contributed to Early Problems, Early Defaults, and Unnecessary SBA Losses

Material origination and closing deficiencies were identified in 32 of the 39 Recovery Act loans reviewed, which were approved for $5.5 million. As of June 11,2010,25 of the loans had been purchased by SBA for $375,259. As shown in Table 1 below, 32 loans had creditworthiness/repayment ability and/or equity injection deficiencies. Three of the loans also had eligibility issues. We believe these material deficiencies caused or contributed to the early loan defaults or early problems. To prevent similar instances of noncompliance, SBA should implement a process for providing feedback to SBA employees and lenders when deficiencies are identified. A listing of loans with material deficiencies is provided in Appendix III and a summary of deficiencies by loan is provided in Appendix IV.

SBA either agreed or proposed actions that were responsive to all of the recommendations.

Table 1. Material Deficiencies Noted in 32 Loans

To view Table 1, please see the attached document.

Creditworthiness/Repayment Ability

Our audit identified 30 loans approved for approximately $3.6 million for which lenders and SBA did not properly assess creditworthiness/repayment ability. 13 CFR § 120.150 states that the applicant must be creditworthy, and loans must be so sound as to reasonably assure repayment. Standard Operating Procedure (SOP) 50 10 requires lenders to analyze each application in a commercially reasonable manner, consistent with prudent lending standards. If a lender's financial analysis demonstrates that the applicant lacks reasonable repayment ability from the cash flow of the business, the loan request must be declined.

Credit Scoring Matrices

Twenty of the 30 loans were made by 2 lenders that used credit scoring matrices that did not comply with SBA requirements. Eighteen of the loans were attributed to an existing lender, and the remaining loans were made by a lender that no longer makes SBA loans. SBA policy allows the use of business scoring models that reasonably ensure repayment and have been validated as being predictive of loan performance. The scoring matrices used by the two lenders were primarily based on personal information (including home ownership and personal credit reports), and limited business factors (such as business income and age of business), which were not verified. Furthermore, lenders used these matrices to determine the size of the loans to approve for individual borrowers, which resulted in borrowers receiving smaller loans than were requested for 11 of the 20 loans. We also identified borrowers that were approved for loans even though they did not meet the matrix criteria. A recent OIG audit of the Community Express Pilot Program found similar occurrences in approximately half of the loans reviewed. (5) Borrowers made minimal payments on these loans and as a result, they defaulted and ultimately were purchased by SBA for $202,344, or 98 percent of the original SBA guaranty amoun(t.

A July 31, 2009 Safety and Soundness Review of one of the two lenders identified [FOIA ex. 8] An SBA official also informed us that the lender's scoring matrix had not been validated for its predictability as required by SBA. Additionally, the lender had a high early-default rate. For example, as of May 31,2010, the lender had made 7 percent of all Recovery Act loans, yet its loans comprised 29 percent of all Recovery Act loans transferred to liquidation. Furthermore, as of the same date, the lender had made 50 percent of all Community and Patriot Express Recovery Act loans, yet it was responsible for 65 percent of all Community and Patriot Express Recovery Act loans transferred to liquidation.

Repayment Ability

We also found that 10 loans did not have adequate repayment ability due to reliance on old financial information, incorrect cash flow computations, unsupported projections, and reliance solely on personal credit. The following examples illustrate deficiencies identified in these 10 loans:

Lenders relied on old financial information to conduct credit analyses.
- One lender used 2007 personal income of $443,11 0 for a loan approved on April 13, 2009, even though the borrower noted annual income of only $750 on its April 1, 2009 loan application.
- Another lender approved a loan in April 2009 based on a credit analysis performed on the borrower 8 months earlier, although current financial information showed a business loss of $67,278 and a business net worth of negative $91,200. The credit analysis was based on projections instead of actual data because the lender considered the borrower to be a "new business." However, the borrower had been in business for more than 2 years and new financial information was available. Furthermore, the lender made the loan with the knowledge that the borrower had not made substantial revenue during its time in business.
Cash flow was miscalculated due to inappropriate adjustments and excluded expenses.
- Although SBA requires repayment ability to be supported from the cash flow of the business, one lender inappropriately added back $209,000 of personal income and a partner's $29,000 guaranteed payment without explanation. When these items were removed from the cash flow computation, the business did not demonstrate repayment ability.
- For another loan, SBA did not take into consideration approximately $16,800 of expenses when computing cash flow. When all applicable expenses were used, the debt service coverage was 0.59, indicating the borrower lacked repayment ability.
Lenders did not use the actual cash flow method when appropriate.
- For one loan approved for $976,000, a CPA-prepared statement of cash flow included in the lender's loan file demonstrated that the borrower had a cash flow of $24,350, which was insufficient to cover its debt obligations. Instead of using the prepared statement, the lender calculated repayment ability using the rule of thumb method,(6) which resulted in a cash flow estimate that was $402,650 higher than reflected in the CPA's statement. While using the rule of thumb method met SBA requirements in place at the time the loan was made, it was imprudent to ignore a professionally prepared statement and rely solely on a self-prepared rule of thumb computation to support loan approval.

Equity Injection

Our audit disclosed that lenders made two loans without verifying that the required borrower equity was injected into the business. SOP 50 10 states that lenders must verify the equity injection prior to disbursing loan proceeds. Verification of a cash injection requires documentation, such as a copy of a check along with evidence, such as a recent bank statement, showing that the funds were deposited into the borrower's account, or a copy of an escrow settlement statement accompanied by a bank account statement showing that injection into the business was made prior to disbursement. However, as support for $713,000 in equity injection, one lender provided an invoice dated 11 days after loan disbursement showing a deposit was made for the equipment to be purchased with loan proceeds. Furthermore, there was no processed check or bank statement to prove the deposit was actually made, and evidence in the loan file showed the equipment vendor was a partial owner of the business, which posed a conflict of interest between the two parties.

Eligibility

We also found that lenders and SBA did not ensure that borrowers on three loans met SBA's eligibility requirements regarding affiliation, business valuation, and seller control. For example, one loan was approved for $120,500 even though the seller did not relinquish control of the business as required. This resulted in business failure, loan default, and a $61,145 loss to SBA.

OTHER MATTERS

Noncompliance With Recovery Act Documentation Requirements

Our audit identified that lenders did not comply with Recovery Act documentation requirements on 18 loans, 14 of which also had material deficiencies. Under the Recovery Act, a guaranty cannot be made for a loan to any entity that hired, recruited or referred for a fee, an unauthorized alien for employment. To implement this requirement, SBA issued Policy Notice 5000-1098, Implementation o/Section 502 o/the Recovery Act -Up to a 90 Percent Guaranty on 7(a) Loans, which requires lenders to obtain certifications from borrowers. However, we determined that lenders did not obtain immigration certifications for 16 of the 18 loans that were required to have them. Eleven loans with missing immigration certifications were purchased at the higher 90-percent Recovery Act guaranty amount,(7) resulting in a $7,025 loss to SBA. While 10 of these loans also had material deficiencies for which the SBA loss is already being questioned, for one loan, the only deficiency identified was a missing immigration certification. As a result, SBA should obtain the certification for this loan or recover $3,248 from the lender. The remaining four loans have not yet been purchased.

We also found that lenders did not obtain restricted use certifications for the two Recovery Act loans required to have them. Under Section 1604 of the Recovery Act, appropriated funds cannot be used by any State or local government or any private entity for a casino or other gambling establishment, aquarium, zoo, golf course, or swimming pool. To implement this requirement, SBA issued Policy Notice 5000-1105, Recovery Act-Restricted Uses o/Funds, which requires lenders to have the borrower and operating company certify prior to the first disbursement that working capital loan proceeds will not be used for any prohibited use. These two loans have not yet been purchased by SBA.

Recovery Act Loans Were Disbursed Without the Required Form 159

We identified 21 loans for which it appeared lenders had charged packaging fees, without obtaining the required Form 159, Fee Disclosure Form and Compensation Agreement. SBA requires completion of a Form 159 if a packager or referral agent has been used or the lender has charged a fee associated with the application. Furthermore, if a lender has paid a referral fee in connection with an SBAExpress loan, the lender must complete a Form 159. The form is important as it documents the lender's certification that: (1) the services rendered and amounts charged are reasonable and satisfactory; (2) they have no knowledge that any other agent was engaged by, represented, or worked on behalf of the applicant other than in another executed compensation agreement; and (3) referral fees were not charged directly or indirectly to the applicant.

Suspicious Activity Was Identified in Recovery Act Loans

We identified suspicious activity in 10 of the 39 loans we reviewed. These loans have been referred to the OIG Investigations Division.

RECOMMENDATIONS

We recommend that the Associate Administrator for Capital Access:

Reexamine the credit scoring matrix used by 1 lender that made 18 of the 32 loans with material deficiencies to ensure it complies with SBA requirements.
Implement a process for providing feedback to SBA employees and lenders when deficiencies are identified.
For the 25 purchased loans with material deficiencies, require the lenders to bring the loans into compliance or recover the $375,259 in guaranties paid.
Obtain the certification for the loan missing only an immigration certification, or recover $3,248 from the lender.
Flag the other loans that have not yet been purchased to ensure the loan deficiencies are properly addressed at the time of the purchase review.

AGENCY COMMENTS AND OFFICE OF INSPECTOR GENERAL RESPONSE

On August 13,2010, we provided a draft of the report to SBA for comment. On September 17, 2010, SBA provided written comments, which are contained in their entirety in Appendix V. SBA either agreed or proposed actions that were responsive to all five recommendations.

Recommendation 1

SBA agreed to reexamine the credit scoring matrix used by the one lender to ensure it complies with SBA requirements. This comment was responsive to recommendation 1.

Recommendation 2

SBA agreed that providing feedback to SBA employees and lenders when deficiencies are identified is an important internal control and stated that the Quality Assurance Guide being developed includes a feedback and training component for SBA employees. SBA will also evaluate its practices with regard to lenders and will make appropriate adjustments. SBA's comments were responsive to recommendation 2.

Recommendation 3

SBA stated it will review the 25 purchased loans with identified deficiencies and will take appropriate action. This comment was responsive to recommendation 3.

Recommendation 4

Management stated it will review the loan missing only an immigration certification and will take appropriate action. This comment was responsive to recommendation 4.

Recommendation 5

SBA agreed to flag the loans that have not yet been purchased to ensure the loan deficiencies are properly addressed during purchase review if the loans default. SBA's proposed action was responsive to recommendation 5.

ACTIONS REQUIRED

Please provide your management response for each recommendation on the attached SBA Forms 1824, Recommendation Action Sheet, within 30 days from the date of this report. Your responses should identify the specific actions taken or planned to fully address each recommendation and the target dates for completion.
We appreciate the courtesies and cooperation of the Office of Capital Access. If you have any questions concerning this report, please call me at (202) 05-205-[FOIA ex. 2] or Debra Mayer, Director, Recovery Oversight Group, at (202) 205-[FOIA ex. 2].

APPENDIX I. SAMPLING METHODOLOGY

The universe consisted of 65 Recovery Act loans that had been purchased by SBA or placed in liquidation status by lenders as of December 31, 2009. From this universe, we selected a judgmental sample of 39 loans. This included the 27 loans that had been purchased by SBA, the majority of which were Community Express and Patriot Express loans; the 4 largest loans based on gross approval amount; and 8 other loans that were selected based on various judgmental factors. Specifically, we selected one Preferred Lenders Program (PLP) loan that was transferred to liquidation within 2 months after loan approval, two additional loans (one Regular 7(a) and one PLP) due to the limited representation of these loan types in the universe, two SBAExpress companion loans approved on the same date, and three Patriot Express loans to compare to the other defaulted Patriot Express loans made by different lenders. Of the 39 sampled loans, 15 were Community Express, 8 were Patriot Express, 7 were SBAExpress, 6 were PLP, and 3 were Regular 7(a).

APPENDIX II. SAMPLED LOANS

To view Appendix II, please see the attached document.