The Fed just raised interest rates by another 0.75%, putting Main Street economy ‘dangerously close’ to edge of lending cliff

If the Federal Reserve’s FOMC next moves match the market’s expectation for two more interest rate hikes by the end of the year, small business loans will reach at least 9%, maybe higher, and that will bring business owners to a difficult set of decisions. Businesses are healthy today, especially those in the rebounding services sector, and credit performance remains good throughout the small business community, according to lenders, but the Fed’s more aggressive turn against inflation will lead more business owners to think twice about taking out new debt for expansion.

Partly, it is psychological: with many business owners never having operated in anything but a low interest rate environment, the sticker shock on debt stands out more even if their business cash flow remains healthy enough to cover the monthly repayment. But there will also be more businesses finding it harder to make cash flow match monthly repayment at a time of high inflation across all of their other business costs, including goods, labor, and transportation.

“Demand for lending hasn’t changed yet, but we’re getting dangerously close to where people will start to second guess,” said Chris Hurn, the founder and CEO of Fountainhead, which specializes in small business lending.

“We’re not there yet,” he said. “But we’re closer.”

As traditional banks and credit unions tighten lending standards and businesses begin to breach debt covenants based on debt service coverage ratios — the amount of cash flow needed to cover debt — more business owners will turn to the SBA loan market in which firms like Hurn’s specialize.

“Every time we get into one of these cycles and the economy is slowing and rates are going up, one of the few places to get business credit is SBA lenders,” he said.

But even in the SBA market, business owners are beginning to pause as a result of the Fed’s rate actions, said Rohit Arora, co-founder and CEO of Biz2Credit, which also focuses on small business lending. “From a credit perspective, people are getting more cognizant about increasing interest cost, and that the Fed will keep interest rates at 4-4.50%,” Arora said.

Fed officials signaled the intention on Wednesday of continuing to hike until the funds level hits a “terminal rate,” or end point of 4.6% in 2023.

“Even a month ago, this was a ‘2022 phenomenon’ and now they will have to live with the pain for longer,” Arora said. “It’s a harder decision now because you don’t have the Fed ‘put’ behind you,” he added, referring to an environment in which you could bank on adjustable loan rates not going higher.

The big change since the summer, reflected in the stock market as well, is the acknowledgment that the Fed is not likely to quickly reverse its interest rate hikes, as inflation proves stickier than previously forecast, and key areas of the economy, like the labor market, don’t cool fast enough. As recently as the last FOMC meeting in July, many economists, traders and business owners expected the Fed to be cutting rates as soon as early 2023.

Now, according to CNBC’s surveying of economists and investment managers, the Fed is likely to reach peak rates above 4% and hold rates there throughout 2023. This outlook implies at least two more rate hikes in November and December, for a total of at least 75 basis points more, and including Wednesday’s hike, 150 basis points in all from September through the end of the year. And that is a big change for business owners.

The FOMC meeting decision reinforced this expectation of a more hawkish Fed, with the two-year treasury bond yield hitting its highest rate since 2007 and the central bank’s expectations for when it starts cutting rates again pushed out even further in time. In 2025, the fed funds rate median target is 2.9%, implying restrictive Fed policy into 2025.

SBA loans are floating rate loans, meaning they re-adjust based on changes in the prime rate, and that has not been an issue for business owners during the low interest rate environment, but it is suddenly becoming a prominent concern. With SBA loans based on the prime rate, currently at 5.50%, the interest rates are already between 7%-8%. With the prime rate poised to reach 6.25% after the Fed’s latest 75 basis point hike, SBA loans are heading to as high as the 9%-9.5% range.

“Most of the business owners today, because they have lived in such a low rate environment, while they have floating interest rate loans they didn’t even realize that on existing loans it could go up,” Arora said. “Everyone expected with gas prices coming down to what I would call ‘pre-high inflation levels’ that things looked a lot better. Now people are realizing that oil prices don’t solve the problem and that’s new for lots of business owners who thought inflation would taper off and the Fed not be so hawkish.”

He stressed, like Hurn, that demand for business loans is still healthy, and unlike deteriorating consumer credit, small business credit performance is still strong because many firms were underleveraged pre-Covid and then supported by the multiple government programs during the pandemic, including the PPP and SBA EIDL loans. “They are well capitalized and are seeing strong growth because the economy is still doing pretty well,” Arora said, and he added that the majority of small businesses are in the service economy, which is the strongest part of the economy right now.

But many business owners were waiting for the Fed to cut in early 2023 before making new loan decisions. Now, they’ve been caught flatfooted by adjustable loan rates that went up, and an interest rate environment poised to go higher still.

“Lots of business owners look at gas prices first and that was true for most of the year, and now it’s broken down. Wage inflation and rent inflation are running amok, so we’re not seeing inflation coming down anytime soon,” Arora said.

That’s leading to more interest in fixed-rate products.

Demand for fixed-rate loans is going up because businesses can lock in rates, from a year to three years. “Though it’s pretty late to the game, they feel like maybe the next 14 to 15 months, before rates start coming down, they can at least lock in a rate,” Arora said. “The expectation is, in the short term, SBA loans will adjust up and non-SBA loans are shorter tenure,” he said.

SBA loans range from three years to as long as 10 years.

A fixed rate loan, even if it is a little higher than an SBA loan today, may be the better option given the change in interest rate outlook. But there’s considerable potential downside. Trying to time the Fed’s policy has proven difficult. The change from the summer to now is proof of that. So if there is a significant recession and the Fed starts cutting rates earlier than the current expectation, then the fixed-rate loan becomes more expensive and getting out of it, though an option, would entail prepayment penalties.

“That’s the one big risk you run if taking a fixed-rate loan in this environment,” Arora said.

The other tradeoff in choosing a fixed-rate loan: the shorter duration means a higher monthly repayment amount. The amount a business can afford to pay back every month depends on the amount of income coming in, and a fixed rate loan with a higher monthly repayment amount requires a business to have more income to devote to servicing the loan.

“After 2008, business owners never experienced a jumped in SBA loans and now they see monthly interest payments increasing, and are feeling the pinch and starting to plan for it … get adjusted to the new reality,” Arora said. “Demand is still healthy but they are worried about the increased interest cost while they are still battling inflation, even as lower oil prices have helped them.”

Another cost that is suddenly influencing the SBA loan decision is the end of a waiver this month on SBA loan guaranty fees that are traditionally charged to borrowers so that in the event of a default, the SBA pays the portion of the loan that was guaranteed.

With that waiver ending in September, the cost of guaranteeing a loan can be significant. For example, a 3% SBA guaranty fee on a $500,000 loan would cost the business borrowing the money $15,000.

“It’s adding to the costs,” Arora said.

While oil prices are coming down, food and other inventory costs remain high, as do rent and labor costs, and that means the need for working capital isn’t changing. And business owners who have been through downturns before know that the time to access credit is before the economy and cash flow start to deteriorate. At some point, in the most severe downturns, “you won’t get money at any cost,” Arora said.

“If you have a reasonably calculated growth plan, no one is going to say keep your head in the sand and wait until Q2 of next year and see where rates are,” Hurn said. “Banks don’t like to lend when the economy is slowing and there are higher rates, which translate to higher risk of defaults.”

Hurn said loan covenants are being “tripped” more frequently now in deteriorating sectors of the economy, though that by no means typifies the credit profile on Main Street.

“Once interest rates go up, and if inflation does not go down, we will see more debt service coverage ratios getting violated,” Arora said. This has to be taken into account because here is a lag between Fed policy decisions and economic impact, and this implies that sticker forms of inflation will last for longer even as sectors like housing and construction are deteriorating.

Much of the surplus liquidity businesses are sitting on due to government support is being eroded, even amid healthy customer demand, because of high inflation. And even if this economic downturn may not be anything like the severe liquidity crisis of 2008, business owners are in a better position when they have the access to credit before the economic situation spirals.

The systemic issues in the financial sector, and the liquidity crisis, were much bigger in 2008. Today, unemployment is much lower, lender balance sheets are much stronger, and corporate balance sheets are stronger too.

“We’re just running into a slowing economy,” Hurn said.

When he started in small business lending back in 1998, business loans reached as high as 12% to 12.5%. But telling a business owner that today, like telling a mortgage borrower that rates used to be much higher, doesn’t help after an artificially low interest rate era.

“Psychologically, people set their expectations for borrowing costs … ‘they will be this cheap forever,'” Hurn said. “It’s changing radically now.”

“If rates go close to 10%, psychologically, businesses will start hesitating to borrow,” Arora said.  

And with a peak Fed rate level of 4% or higher reached by late this year, that is where SBA loan rates are heading.

Another 150-175 basis points in total from the Fed, if it has its intended effect of bringing inflation down, would leave many businesses in a stable condition because all of the other costs they are facing outside of debt would be more manageable. But the key question is how quickly the interest rate actions bring down inflation, because the higher rates will impact the cash flow of businesses and their monthly loan payments.

Lower inflation in stickier parts of the economy, like labor, combined with energy costs remaining lower, would allow small businesses to effectively manage cash flow. But if those things don’t happen as quickly as people are expecting, “then there will be pain, and consumer spending will be down too, and that will have a bigger impact,” Arora said. “The challenge is recession and high interest rates together that they have to handle and haven’t seen in 40 years,” he said.

Rates are not ordinarily considered the determining factor in a business’s decision to take out a loan. It should be the business opportunity. But rates can become a determining factor based on the monthly repayment amount, and if a business is looking at cash flow against monthly costs like payroll being harder to make, expansion may have to wait. If rates go up enough, and inflation doesn’t fall off fast enough, all borrowing may need to be applied to working capital.

One thing that won’t change, though, is that the U.S. economy is based on credit. “People will continue to borrow, but whether they can borrow at inexpensive rates, or even get capital trying to borrow form traditional sources, remains to be seen,” Hurn said.