How the Surge in Consumer Lending Has Squeezed Small Businesses Dry

NEW YORK — In 1991, Rob Kaufelt bought a little cheese shop in Greenwich Village. Like many other businesses on Cornelia Street at the time, Murray's Cheese had sold lovingly crafted foods for years and years. Its future, like that of its neighbors, looked bleak. With all of the hand-wringing over cholesterol and before the Atkins diet, fancy cheese was no growth market. It certainly wasn't a smart place to invest, though that is what Kaufelt did when he acquired Murray's Cheese from its second owner.

Now it is a New York institution. Murray's has been profitable every year since 1991; this year, it expects sales to reach $20 million. Forbes declared it the world's best cheese shop. The nation's largest grocery chain, Kroger's, has even arranged to set up mini-Murrays in at least 50 of its stores.

So why have some of the nation's largest banks, sitting on piles of cash, turned Kaufelt down for loans to bolster his small business's growth? Like most Americans, Kaufelt can borrow for a roof, a car, or a couch. But his profitable and stable business can't. Understanding the difference between a cheese shop and a home mortgage goes far to explain the underlying crisis in our credit system today.

Baby boomers are prone to doubt that their parents ever indulged in debt. Instead, they like to think that their Depression-era parents flourished in the 1950s by saving pennies. Lamenting the loss of a nobler generation's virtue of thrift — in their own lives and in their children's — baby boomers have tended to regard the Great Recession not only as a financial fiasco but also as a moral failure.

It's all a myth. The Greatest Generation drove financed cars from mortgaged homes to department stores, where they charged their purchases and then deducted the interest from their taxes. In many ways, consumers' incentives to borrow were even stronger then than they are today. What constrained borrowing after World War II wasn't Americans' thriftiness but, rather, banks' unwillingness to lend money to consumers.

For the lender, every debt is an investment carrying a risk and a return. Today, as in the 1930s, the hard times have lingered in part because big banks' fears about the economy have prompted them to sit on their cash. During the Depression, New Deal agencies such as the Federal Housing Administration and Fannie Mae reassured private investors that it was safe to put their money into mortgages by guaranteeing repayment of the loans if homeowners defaulted. Soon, banks diversified from mortgages into other forms of consumer lending. Bank of America, for instance, got involved with FHA mortgages in 1934 but, within a few years, also offered cash loans, car financing, and other forms of consumer lending.

From the 1930s through the 1960s, consumer borrowing remained limited to the capital that banks and investors had on hand. These limitations began to relax in the 1970s as lenders started to divert money from capital markets — traditionally devoted to business borrowing — to consumer loans. Mortgage-backed securities, first issued by Fannie Mae in 1970, pooled millions of dollars in mortgages, whose monthly repayments of principal and interest were channeled through the new securities to investors. Banks and nontraditional investors such as pension funds found it painless — and safe — to invest.

It was this access to capital markets, more than any other factor, that brought our leveraged society to life. For an individual mortgage, the risk of default is tricky to calculate. But for pools of mortgages, an investor can rely on what statisticians call the law of large numbers to find the average rate of default. While the future of individual loans can't be known, the financiers believed that they could figure the average outcome for a group of loans. Car and credit-card loans have undergone the same pooling-and-sales since the late 1980s. Securitization expanded the universe of possible investors to nearly anyone in the world. It became as easy and seemingly low-risk to invest in consumers as in corporations.

Until it wasn't. The ever more elaborate financial instruments, designed to balance risk and return, encouraged riskier subprime loans in quantities that touched off the Great Recession. As a result, lending practices have tightened for pretty much everyone.

So what did this mean for cheese? Even before the recession, small businesses were finding it tough to line up loans. In earlier decades, they could easily obtain a line of credit at the local bank, which had few other places to put its capital. With consumer loans surging and big corporations able to borrow as easily as ever, small businesses got squeezed out. While securitized loans to consumers looked easy, liquid, and low-risk, loans to small businesses were labor-intensive, illiquid, and risky — everything that lenders try to avoid. Unable to obtain a revolving line of credit to buy and sell more cheese, Murray's Cheese — like so many other small businesses — has been forced to resort to its own profits to finance its growth, necessarily limiting how quickly it could expand. In some ways, Murray's is lucky, for many owners finance new businesses nowadays on their credit cards.

"Zero interest rates won't help American cheese mongers if they can't get a loan," Kaufelt said. In his mind, the financial world has failed small businesses, which account for nearly two-thirds of the economy's new jobs. Even after the 2007 recession, according to the Securities Industry and Financial Markets Association, more money is invested in consumer debt ($10.4 trillion) this year than in corporate bonds ($7.6 trillion).

What if the financial stratagem that got us into this mess could help get us out? Here's a thought: Securitize loans to small businesses like those to consumers, as a way to bolster the credit-starved employers that goose the common good. Bundling the debt of cheese shops with those of florists and contractors and T-shirt makers, then selling these as securities to investors, might draw capital away from dead-end consumer loans and into businesses that create jobs. As long as the economic growth thus generated exceeds the risk that Murray's Cheese et al will fail, this would bring more tax revenue into governments that need every cent. Paradoxically, a solution to reducing the national debt may lie in making it easier for businesses to borrow.

The writer teaches economic history at Cornell University. He is the author of Debtor Nation: The History of America in Red Ink, published earlier this year, and of Borrow: The American Way of Debt, to be published next January.