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Tuesday, December 21, 2010

"The Effect of Falling Home Prices on Small Business Borrowing"

I didn't realize how much small businesses depend upon home equity to finance their business operations:

The Effect of Falling Home Prices on Small Business Borrowing, by Mark E. Schweitzer and Scott A. Shane, Economic Commentary, FRB Cleveland: Small businesses continue to report problems obtaining the financing they need. Because small business owners may rely heavily on the value of their homes to finance their businesses (through mortgages or home equity lines), the fall in housing prices might be one of the causes of their difficulty. We analyze information from a variety of sources and find that homes do constitute an important source of capital for small business owners and that the impact of the recent decline in housing prices is significant enough to be a real constraint on small business finances.
A persistent issue throughout the recovery has been the reported inability of small businesses to get the financing that they need. To better understand the sources of any shortfall, the Federal Reserve System undertook a project in 2010 to meet with representatives from banks and small businesses.1 In some of the focus groups..., participating small business owners explained that the reduced value of their homes has made it difficult for them to provide the necessary collateral for small business loans. Other participants said that the reduced value of homes has made home equity borrowing as a source of business capital more difficult to come by, also contributing to the difficulty many small businesses face in obtaining sufficient capital to finance their operations. While the small business owners’ message of a link between home values and small business borrowing came through loud and clear in the focus groups, the process did not provide estimates on the magnitude of the effect of declining home values on small businesses’ access to capital. ...
This Commentary analyzes information from a variety of sources in order to quantify the connection between home values and small businesses’ access to capital. Specifically, we examine the extent to which small business owners use their homes to finance their businesses, the rise in the use of homes as a source of capital for small businesses during the housing boom, the magnitude of the effect of housing price declines on small business finance, and the variation in these issues across states, industries, and types of small businesses. Our analysis reveals that the magnitude of the effect of home prices on small business finances is large enough to be a real constraint on ... the growth of small businesses...
Of course, not all small businesses have been equally affected by the decline in home prices. While many small business owners use residential real estate to finance businesses, not all do. Those more likely do so to include companies in the real estate and construction industries, those located in the states with the largest increases in home prices during the boom, younger and smaller businesses, companies with lesser financial prospects, and those not planning to borrow from banks. ...
The link between home prices and small business credit poses important challenges for policy makers seeking to improve small business owners’ access to credit. The solution is far more complicated than telling bankers to lend more or reducing the regulatory constraints that may have caused them to cut back on their lending to small companies. Returning small business owners to pre-recession levels of credit access will require an increase in home prices or a weaning of small business owners from the use of home equity as a source of financing. Neither of those alternatives falls into the category of easy and quick solutions.

Many businesses that fail in recessions due to insolvency problems would be viable if they could find the resources they need to hold on until the economy recovers. At the very time these firms need financing the most, deterioration in the financial position of the business combined with the loss of collateral due to declining home values and declining asset values more generally makes the financing harder to obtain. We could do more to help these firms survive recessions, and in doing so help to stabilize employment.

    Posted by on Tuesday, December 21, 2010 at 12:30 AM in Economics | Permalink  Comments (23)


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