How the 2008 Financial Crisis Killed Small Business Lending

Everyone saw it coming. Nobody did anything about it.

That’s the short version of what happened between 2001 and 2008 in American finance. Charles H. Green lived through it as a banker. In Chapter 3 of The Banker’s Guide to New Small Business Finance, he lays out exactly how the capital markets blew up and what it meant for small businesses trying to get funded.

The Setup

The dot-com bust hit. Then 9/11 happened. The economy wobbled but didn’t fall over. And then something weird started. The money got really loose.

Banks started handing out mortgages to basically anyone. CDOs (collateralized debt obligations) became the hottest product on Wall Street. Liar loans were everywhere. People were getting 100% financing on homes they couldn’t afford.

Green paints a picture that sounds insane in hindsight. Single mothers owning rental properties. New attorneys buying $400,000 condos on interest-only loans. Nobody questioned it because housing prices only went up. The whole system ran on the assumption that the music would never stop.

It stopped.

90 Days That Broke Everything

Green walks through a timeline from September to November 2008 that reads like a horror movie. The numbers are staggering.

Here’s what collapsed in roughly 90 days:

• Fannie Mae and Freddie Mac placed into conservatorship. $6 trillion in mortgage obligations.
• Merrill Lynch sold to Bank of America. $50 billion.
• Lehman Brothers filed for bankruptcy. $639 billion. The largest bankruptcy in U.S. history.
• AIG bailed out by the Fed. $209 billion.
• Washington Mutual seized by the FDIC. $63 billion. The largest bank failure ever.
• Wachovia sold to Wells Fargo. $15 billion.
• TARP (Troubled Asset Relief Program) passed by Congress. $700 billion.
• Citicorp got a government bailout. $326 billion.
• TALF (Term Asset-Backed Securities Loan Facility) launched. $1 trillion.

Add it up. That’s $9.127 trillion in financial chaos. In three months.

Let that sink in for a second. Nine trillion dollars. Gone, seized, restructured, or propped up by the government. In 90 days.

Small Businesses Got Crushed

Here’s the part that matters for this book. When the financial system melted down, $2.7 trillion in credit lines collapsed. Just vanished.

Banks that were still standing got scared. Really scared. They pulled back on lending across the board. And small businesses were the first to get cut off.

Big corporations could still tap the bond markets or get emergency lines of credit. Small businesses had no such options. Their banker was either gone (because the bank failed) or terrified (because regulators were breathing down their neck). Either way, the money dried up overnight.

The Government Response

The government tried to help. In 2009, Congress passed the American Recovery and Reinvestment Act (ARRA), which included $730 million directed at the SBA.

Green describes it as a “hand-up, not a hand-out.” The SBA didn’t just throw cash around. They made structural changes to their loan programs:

• Raised the guarantee on 7(a) loans from 75% to 90%. This meant banks were on the hook for less if the borrower defaulted. Which meant banks were more willing to lend.
• Eliminated borrower fees on SBA loans. This made SBA loans cheaper for small businesses.

Then in 2010, Congress passed the Small Business Jobs Act. This raised SBA loan limits to $5 million. Before that, the ceiling was lower. More money became available for bigger projects.

These were real, meaningful changes. But they took time to work through the system. And in the meantime, small businesses were still struggling.

The Supply vs. Demand Debate

Here’s where it gets interesting. After the crisis, there was a big argument about what actually happened to small business lending. Was it a supply problem (banks wouldn’t lend) or a demand problem (businesses didn’t want to borrow)?

Green points to data from Pepperdine University that tells a nuanced story. Only 26% of businesses even tried to raise capital after the crisis. And 70% of businesses said they didn’t need outside funding at all.

So it wasn’t just that banks stopped lending. Businesses also stopped asking. The crisis scared everyone. Business owners saw what happened to people who were overleveraged. They pulled back too.

The truth is it was both. Supply dried up AND demand dropped. The whole ecosystem contracted at the same time.

How Deregulation Lit the Fuse

Green doesn’t let the regulatory side off the hook. He traces the crisis back to specific deregulation decisions.

The Gramm-Leach-Bliley Act (GLB) repealed Glass-Steagall, the Depression-era law that kept commercial banking and investment banking separate. That wall existed for a reason. Once it came down, banks started taking risks they were never designed to handle.

The Commodity Futures Modernization Act (CFM) exempted derivatives from regulation. This is what let CDOs and credit default swaps grow into a monster nobody could control.

Green notes that even Alan Greenspan, the former Fed chairman and one of the biggest champions of free markets, admitted after the crisis that he had put too much faith in deregulation. That’s a pretty big concession from someone who spent decades arguing the opposite.

After the crash, Congress passed the Dodd-Frank Act. More regulation. Tighter oversight. Stress tests for banks. The pendulum swung hard the other way. And while Dodd-Frank was designed to prevent another 2008, it also made it harder for banks to lend to small businesses. More paperwork. More compliance costs. More reasons to say no.

The Bank Failure Numbers

Green puts the bank failure data in perspective and the numbers tell a clear story.

From 1980 to 1994 (the savings and loan crisis era), 2,935 banks failed. That was ugly. Then things calmed down. From 1994 to 2007, only 58 banks failed. Thirteen years of relative stability.

Then 2008 hit. Since 2007, 505 banks have failed.

That’s not just a statistic. Every failed bank had small business customers who suddenly had to find a new lender. Every failed bank had loan officers who knew their local market and had relationships with business owners. All of that institutional knowledge and those relationships just disappeared.

The Bottom Line

Chapter 3 is really about setting the stage. Green is building toward his bigger argument, which is that the 2008 crisis created a vacuum in small business lending. Banks couldn’t fill it. The SBA helped but couldn’t fill it alone. And into that vacuum rushed a wave of new players with new technology and new money.

That’s what the rest of the book is about. But you can’t understand the new world without understanding how completely the old one fell apart.

Nine trillion dollars in 90 days. $2.7 trillion in credit lines gone. 505 bank failures. These aren’t abstract numbers. They represent the moment when small business finance changed forever.

This post is part of a series on The Banker’s Guide to New Small Business Finance by Charles H. Green, published by Wiley in 2014.

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