Private lenders did not use prudent lending practices for a small business program that President Barack Obama hopes to expand to improve the economy, a government watchdog said on Wednesday.

The U.S. Small Business Administration's inspector general found weakness in more than two-thirds of loans it examined in a program aimed at encouraging construction projects.

Some $255 million worth of these so-called 504 loans were made to borrowers who might not be eligible or might not be able to repay them, Inspector General Peggy Gustafson estimated in testimony to the House Small Business Committee.

The Obama administration has proposed raising the maximum size of these loans to $5 million from $2 million as part of its efforts to help the economy recover from the worst recession in 70 years.

Eight of these private lenders also paid more than 20 percent of their gross receipts toward executive compensation, reducing the amount of funds available for other loans, Gustafson said.

SBA regulations require that excess funds be used for investment in other economic activity, but one lender retained almost 44 percent for executive compensation, she said.

The SBA needs to ensure that its rules are being followed, House Small Business Committee Chairwoman Nydia Velazquez said.

Given the challenges entrepreneurs face finding affordable credit, it is imperative that the Small Business Administration's capital access programs function correctly, she said in a statement.

In a tight budget environment, the Obama administration has requested a $2 million increase for the agency's lender oversight efforts, the SBA chief said.

I know we moved in the right direction this past year and we'll continue to take even bigger steps in the future, SBA Administrator Karen Mills said.

(Reporting by Andy Sullivan, Editing by Stacey Joyce)

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