How the Housing Bubble Explains the Small Business Mess

One of the places where some economists see bright spots for the US economy next year is the return of small business investment. For the last two years, small businesses have been starved for credit for a few reasons. The weak economy has hurt demand for their goods and services, so businesses see no reason to expand. The recession's impact on profit means small business have worse credit and qualify for fewer loans. And the economic climate, combined with tighter regulations, have made banks reluctant to lend to riskier small firms.

Some economists think the credit freeze might be coming to an end. But a new report from the Cleveland Federal Reserve says small business lending, like so much of the Aughts' economy, was propped up by inflated housing prices and home equity loans. The housing bubble pop continues to weigh on small business expansion:

The decline in home values has constrained the ability of small business owners to obtain the credit they need to finance their businesses.

Those more likely to [use residential real estate to finance businesses] 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.

Once again, even if most indicators are turning up outside of the housing market, ongoing weakness in real estate continues to reach into all sectors of the economy.

Read the full story at Cleveland Fed.