Did small business owners’ borrowing against their homes during the real estate boom sow the seeds of their current problems getting credit? It’s an intriguing hypothesis and one for which we have some supporting data.
Many small business owners finance their companies by borrowing money personally and putting the proceeds of their loans into their businesses or by pledging personal assets as collateral to obtain business loans. Because the biggest asset most people have is their homes, this means that a sizable chunk of small business owners rely on home equity to finance their companies.
A survey of approximately 1,000 small business owners conducted by Barlow Research in 2007 shows that one quarter either used their homes as collateral for business loans or took personal loans against the equity in their homes to finance a small business.
Moreover, during the pre-recession part of the 2000s, small business owners increased their reliance on their homes as a source of business capital. Barlow Research’s data show that the share of small business owners using their homes to finance their businesses increased from 19.5 percent in 2000 to 27.5 percent in 2006.
The decline in home prices has reduced small business owners’ access to credit. In response to the higher level of non-performing real estate loans in their portfolios, banks have tightened their lending standards for home equity loans. At the same time, falling home prices have weakened small business owners’ personal balance sheets, reducing their creditworthiness. In addition, the 28 percent decline in housing prices since March 2006 has wiped out the equity that the typical small business owner borrowed against, given a standard a loan-to-value ratio of 80 percent.
The reliance on homes as a source of business capital was greater in the states with larger declines in home prices. Using data from a survey of small company owners undertaken by the Gallup Organization in the Fall of 2009, colleagues at the Federal Reserve Bank of Cleveland and I found that that small business owners in the states with the largest decline in home prices (Arizona, California, Florida, Michigan and Nevada) were significantly more likely to use their homes to finance their businesses, even after the effects of other factors had been accounted for.
In short, small business owners’ use of their homes to finance their businesses during the real estate boom contributed to the contraction in small business credit markets during the recession, particularly in the states hardest hit by the housing price declines.