NEW YORK -- The crumbling condition of small business loans is threatening to hamstring the recovery of the U.S. economy, and tag banks with rising losses over the coming year.

The U.S. government's Small Business Administration said losses from loans made through its lending programs more than doubled in 2008, reaching nearly $1.3 billion. In 2007, the SBA charged off -- or took permanent losses against -- $504 million of the loans; in 2005, it charged off a much smaller $276 million.

From October through December of last year, Bank of America Corp. said it took permanent losses on about 2.9% of its outstanding small business loans, an annual loss rate of almost 12%. As of one year ago, the Charlotte bank's permanent loss rate on small business loans was about half its current level, or about 6%.

Ken Lewis, the bank's chief executive, called the loans a "damn disaster" last fall.

In aggregate, small business can have a big impact on the economy. Many economists estimate small businesses provide half of all jobs nationwide, although some academics dispute that figure. Perhaps just as crucially, small businesses also typically pay local taxes and also support local real estate economies by filling smaller commercial store fronts and office spaces.

As banks grapple with rising commercial real estate delinquencies, and as states face dwindling tax revenues, troubles within the small business sector will only make banks' headaches more painful.

Besides Bank of America, a number of other lenders also singled out small business loans as a source of rising problems during last year's fourth quarter.

Century Bancorp Inc. recently said its nonperforming assets -- or loans nearing default -- in large part increased due to problems with "consumer mortgages and small business loans."

Capital One Financial Corp. said in January that its levels of nonperforming small business loans rose to 1.79% during the fourth quarter, up nearly 70% over a year ago.

Most lenders do not write nearly as many small business loans -- which are generally considered to be unsecured loans of less than $100,000 -- as they do mortgages, credit cards and corporate loans.

But small business-related problems are likely contributing to losses among other loans, especially credit card and home equity loans, which are going bad at quickly rising rates.

That's because small business owners often fund their concerns with home equity loans instead of classic unsecured credit card-like loans, which charge much higher interest rates.

The contribution of small business problems to home equity loan losses is "a given," said Nancy Bush, a bank analyst and founder of NAB Research LLC. "A lot of small business owners, like me, use home equity loans as back-up lines of credit."

The woes of the small business sector are also likely fueling losses among personal credit cards, says Dr. Michelle White, a professor of economics at the University of California San Diego.

Ms. White says many entrepreneurs fund their ventures, especially new ventures, using personal credit card debt linked to the entrepreneur's own personal credit. Banks issue most personal credit cards by using automatic underwriting programs, making it even more difficult to know how many personal credit card delinquencies are actually due to a failing small business venture.

"In a lot of cases," Ms. White said, "I don't even think the lenders knew what the money was being used for."

It was only recently Bank of America pushed further into small business lending by reducing its underwriting standards in order to write more loans.

Until August of 2006, Bank of America lent money only to businesses that had existed for at least two years. But just more than two years ago, the firm started offering unsecured credit lines of up to $100,000 to startups.

"A small business owner in business for only one day could qualify," the bank said in a press release at the time. For loans under $50,000, a small business didn't have to provide financial records -- a practice that led to big problems in mortgage lending.

As the U.S. economy has slipped deeper into recession, lawmakers and government officials have called for measures to support small businesses, which often have less cushion against operating losses and are therefore particularly vulnerable during economic downturns.

Under Gov. Jon Corzine, for example, New Jersey has said it will send small businesses a $3,000 check for every new hire.

Politicians and regulators have also called for banks to keep writing new loans, including loans to small businesses, even as those same banks continue to reel from losses on existing loans.

Lenders are quick to say demand for small business has fallen on sliding economic activity, making it hard to find new borrowers.
Some entrepreneurs disagree.

Clifford Schorer, a professor of entrepreneurship at Columbia University who also helps graduate students launch their own businesses, says at the moment, many small business owners don't even bother applying for new loans, since they assume there's almost no chance of being approved by loss-scared lenders.

Said Mr. Schorer of the reported decline in demand: "It's certainly not for lack of need for capital."

Write to Marshall Eckblad at marshall.eckblad@dowjones.com.