Agriculture lending presents sort of a conundrum for commercial lenders today. While there is certainly plenty of opportunity for community banks in the ag lending arena, there are also some significant risks. In fact, one of the funniest Yogi-isms from the oft-quoted Yogi Berra may apply to the current state of agriculture lending: “It’s déjà vu all over again.”
Back to the Future
Back in the late 1970s and early 1980s, a number of different factors came together that led to a crash in U.S. agriculture prices and a subsequent wave of bank failures. Among these factors were a rapid escalation in land prices, strong export demand to a single foreign country (the former U.S.S.R.), liberal farm lending standards, easy access to credit for U.S. farmers and heavy farmer debt loads.
When a grain embargo to the U.S.S.R. was implemented and a change in monetary policy resulted in the U.S. becoming the world’s high-priced supplier of grain, U.S. farm exports declined significantly and farm income fell dramatically. Many debt-laden farms got into financial trouble quickly, bringing down some of the banks that loaned to them and nearly collapsing the U.S. Farm Credit System.
Fast-forward about 30 years and there are some potentially alarming parallels today. Once again, land prices in some parts of the country have been bid well above what farm income streams can support. Meanwhile, many farmers today are heavily reliant on exports not just to one country, but to a handful of emerging nations, including the BRICS nations (Brazil, Russia, India, China and South Africa) and the KIMT nations (South Korea, Indonesia, Mexico and Turkey).
In addition, some other factors are contributing to what some see as a farming asset bubble today:
- Ethanol mandates – Ethanol now accounts for 45 percent of the U.S. corn crop, up from just 14 percent in 2003. And last June, the EPA gave final approval for the use of E15 ethanol blends in 2001 and newer vehicle years.
- Cheap dollar and low interest rates – The cheap dollar encourages exports and low rates make it easier for farmers to load up on debt.
- Flat stock market – With the stock market basically flat for the past decade, farmland has become an attractive alternative investment for many.
- Volatile oil prices – Eighty percent of farm expenses are related either directly or indirectly to oil, the average annual price of which has bounced between $53 per barrel in 2009 and $93 per barrel in 2012.
A Commodity Price Super-Cycle
Dr. David M. Kohl, Professor Emeritus of Agricultural Finance and Small Business Management at Virginia Tech, is one of the nation’s leading agribusiness experts. He notes that the U.S. has been in a commodity price super-cycle for the past 10 years, which has helped insulate many rural and agricultural communities from the worst of the Great Recession. “Only four of these super-cycles have occurred in
the past 100 years, and they typically only last about three to four years.”
As a result of this longer-than-normal super-cycle, many younger farmers have never experienced an agricultural economic downturn. “The lengthy current super-cycle has bred a bit of complacency in some rural communities among farmers and farm lenders,” notes Dr. Kohl.
Another potential risk factor is the heavy concentration of debt among what Dr. Kohl calls the “alpha dog” farms. He notes that about 10 percent of the nation’s 2.3 million farms carry about 60 percent of all farm debt. “This is a challenge for community banks because when they lend to these large farms, they’re actually lending to a web of complex businesses. You can build up an agricultural loan portfolio quickly, but if one of these big farms goes down, look out. Alpha dogs bite.”
This scenario can be a community bank underwriter’s worst nightmare because, on the surface, the farm balance sheet may indicate that there’s little actual debt. So you have to dig deeper and look at non-financial factors as well. For example, how aggressive is the farm in its growth strategy? Are they maintaining their business capitalization? Are they holding onto cash and building liquidity and working capital for possible market corrections?
Some alpha dog farms may simply be too big for community banks to finance. “If a large farm needs a $3 million line of credit, that represents a substantial risk to a community bank’s portfolio,” Dr. Kohl notes.
On the opposite end of the spectrum, small farms may represent a different kind of risk. A producer with a relatively small amount of owned acreage that owns a lot of equipment and has leased significant acreage from other owners (typically retired farmers or investors) fits the very profile of a high- risk ag borrower, says Dr. Kohl. “Volatility in commodity prices can turn this farm upside down very quickly. Corn can drop from $9 to $3 a bushel almost overnight, which drastically shifts the farm’s margins.”
Balancing Risk vs. Reward
Given all of this, how can community banks continue to take advantage of the opportunities presented by ag lending while shielding themselves from the risks?
- Perform careful due diligence on all farms before lending money. Restrict lending to farmers who are proven producers and who practice conservative financial management, including modest debt. This includes the farmer’s personal lifestyle — is it extravagant? Does the farmer have “shiny fever,” buying all the latest and greatest technology and equipment regardless of its projected return on investment?
- Target experienced farmers who have demonstrated the ability to manage risk. Does the farmer have a good understanding of the operation’s fixed and variable costs? Are futures and options being utilized? Are the farm’s financial records thorough and well-organized?
- Don’t lend more money than the farm’s projected income stream will support. Set a firm limit on how much money the bank will lend per acre by determining the cost to plant and harvest the crop, the projected yield per acre and the anticipated selling price. The formula: Yield x Price – Cost = Income Per Acre x Cap Rate = Value Per Acre x Bank’s Collateral Advance Rate = Loan Amount Per Acre.
- Remember the “3 Cs” of farm lending. The agriculture industry’s 3 Cs of farm lending are as follows: Be Conservative during the good times, and Consistent all the time, so you can be Courageous during the tough times.
“There’s a lot of opportunity for community banks in agriculture lending. Farming is a very capital-intensive business and farms need lots of operating funds,” says Dr. Kohl. “Also, more young people are entering farming due to the economy and job situation. But community banks need to be very careful to protect themselves from the significant risks involved in agriculture lending as well.”
To discuss the opportunities and risks of agriculture lending in more detail, please give us a call 417-881-0145.