by Calculated Risk on 12/20/2010 02:16:00 PM

From Mark Schweitzer and Scott Shane at the Cleveland Fed: The Effect of Falling Home Prices on Small Business Borrowing

The researchers analyze small business borrowing, and note that homes equity borrowing is 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."

Here is their conclusion:

Everyone agrees that small business borrowing declined during in the recession and has not yet returned to pre-recession levels. Lesser consensus exists around the cause of the decline. Decreased demand for credit, declining creditworthiness of small business borrowers, an unwillingness of banks to lend money to small businesses, and tightened regulatory standards on bank loans have all been offered as explanations.

While we would agree that these factors have had an effect on the decline in small business borrowing through commercial lending, we believe that other limits on the credit of small business borrowers are also at play and could be harder to offset. Specifically, the decline in home values has constrained the ability of small business owners to obtain the credit they need to finance their 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. These patterns are also evident in the data sources we examined.

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.

There is no easy replacement for this source of borrowing.