A TARP-free revamp for $30 billion lending plan

NEW YORK (CNNMoney.com) -- President Obama and several members of Congress are drafting legislation for a new, $30 billion fund that would infuse community banks with capital specifically earmarked for small-business lending.

The plan is the latest spin on a proposal Obama first unveiled in October and touted in his State of the Union address. The idea went nowhere, thanks in part to the unpopularity of Obama's plan to fund the program with money from the Trouble Asset Relief Program. Congress didn't want TARP treated like a piggy bank, and community bankers didn't want the stigma of taking funds from a program known for Wall Street bailouts.

But small business lending remains a glaring trouble spot -- a critical problem because small companies are traditionally the country's main generator of new jobs. Banks have slashed billions from credit lines, and small firms weakened by the recession are struggling to meet tighter underwriting standards.

A Thursday report from TARP's watchdog, the Congressional Oversight Panel, spotlighted the severity of the shortfall. "Small business credit remains severely constricted," the report's authors wrote. "Unable to find credit, many small businesses have had to shut their doors, and some of the survivors are still struggling to find adequate financing."

How it would work: President Obama's plan, which the House Financial Services Committee is scheduled to explore at a hearing on Tuesday, calls for an ultracheap pool of Treasury capital that small banks can tap to boost their small-business lending.

The program would only be available to banks with assets of less than $10 billion -- ruling out the megabanks that have drawn fire for putting their own interests before their customers'.

Banks with assets of less than $1 billion would be able to borrow an amount equal 5% of their assets, and banks worth up to $10 billion would be eligible for an investment of up to 3% of their assets. More than 8,000 of the country's 8,400 banks would be eligible to participate, the government estimates.

The banks would repay the government's loan at a dividend rate starting at 5%. That rate would drop by 1% for every 2.5% increase in small business lending that the bank shows compared to a 2009 baseline. A lender could cut its dividend rate to just 1% by increasing small business loan portfolio by 10%.

But if the bank reduced its small business lending, its repayment divided would shoot up as high as 7%.

The proposal is similar to the one Obama floated seven months ago, with one key difference: This time, the administration isn't eying TARP for the funds.

"We made the decision that to have a viable small business lending fund that was completely new and separate from TARP, we have to see new legislation," said Gene Sperling, counselor to Treasury Secretary Tim Geithner.

If Congress moves forward on the proposal, they'll have to come up with a plan to fund it -- no small challenge amid rising concerns about the country's soaring debt.

Support for the states: A common complaint from small-business owners is that the lending shortfall can't be fixed through initiatives that rely solely on banks.

The Congressional Oversight Panel backed that view in its report this week. Supply-side solutions may be doomed to failure, it said, because small banks have limited reach and megabanks simply won't start lending again until it's in their financial interests to do so.

To tackle that problem, Obama's latest proposal features a new component: Federal cash for state programs that directly supports small-business credit access. The aim is to disburse emergency funds to shore up successful local initiatives that are about to run out of cash.

Drafted collaboratively by members of the Senate, House and a group of state governors, the program would strengthen nontraditional aid measures like Michigan's Collateral Support Program.

The Michigan venture takes aim at a wonky but critical problem. Banks typically require collateral like real estate or equipment to back their business loans, but the recession has battered the value of such assets. As its collateral value drops, so does a company's access to credit.

That's an especially big problem in Michigan, where many auto suppliers are trying to diversify into other manufacturing fields like clean energy and medical equipment. Retraining workers and retooling factories takes capital -- and credit is scarce for manufacturers in hard-hit areas.

"We even had cases where companies that had never missed a payment and were profitable were losing their bank because the collateral wasn't there to support the lending," said Greg Main, president and CEO of the Michigan Economic Development Corporation.

The Collateral Support Program puts money in the bank to offset the declining value of the borrower's assets. If the borrower keeps paying their bills, the state loses no money: "As the value of the collateral goes back up or the need for collateral coverage goes down, then the bank releases the dollars back to us," Main says.

But Michigan is struggling to fund the program. Half of its $25 million budget is already deployed to back 12 loans, while the Michigan Economic Development Corporation estimates there that outstanding demand could top $1 billion.

That's exactly the kind of initiative the administration wants to route federal cash toward. "We wanted to empower states to move quickly to spark lending and job creation immediately," Sperling said.

The administration estimates that the state lending grants would cost the federal government $1 billion to $2 billion. The subsidy to support the $30 billion capital pool for community banks is estimated to also cost up $2 billion.

That tallies to around $4 billion Congress will need to come up with if it wants to move forward on the initiatives.