Klinefelter: By the Numbers
Tighter Credit Coming
Credit conflicts are on the rise. Some of the reasons are obvious: tighter margins, a series of drought in some regions of the country, elimination of several farm program direct payments and a softening of the land market in most of the country. But those aren't news to anyone who has been paying attention.
It's not unusual for troubled farm customers to already have debt levels that exceed USDA/Farm Service Agency's $1.392 million credit guaranteed limit, so that will eliminate one popular risk mitigation tool that helps keep troubled accounts on lenders' books. Another is that too many farmers and their lenders still have been using cash basis income in their credit analysis. It's been widely known that cash accounting lags accrual-adjusted accounting by up to 2-3 years in reflecting downturns. Under cash accounting, farmers have been building inventories, increasing prepaids and buying equipment primarily for income tax purposes. By reducing these, they can cash flow for a time while the business is actually losing money. In addition, there is production agriculture's multiplier effect on the farm supply sector which spreads the negative impact on lender's loan portfolios.
RESERVES DRYING UP
But, the biggest impact of a downturn is the reduction in farmers' liquidity position. Also, since land makes up more than 80% of farm assets, a decrease in land values and an increase in carryover operating debt increases leverage. Couple these with the fact that many farmers have high multi-year cash rents and the problems can be compounded in coming years. Lenders also have to be forward-looking. If commodity prices, land and used equipment prices don't show any signs of a near-term turn around, lenders have to become more conservative in deciding how long they can continue financing troubled borrowers. There has also been an uptick in the number of farm bankruptcies, adding to lender anxiety.
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In addition, both commercial banks and the Farm Credit System are facing the implementation of risk-capital banking rules known as Basel III. Regulators will require lenders to have more capital and for it to be risk based, depending upon the quality of their loan portfolio. That means a surge in poor-quality loans will be more painful for banks than in the past and give them less leeway in dealing with troubled borrowers.
Another factor often not obvious to producers is that bank and Farm Credit examiners become aggressively proactive and require stricter standards on loan underwriting, credit analysis, loan risk rating and justifying why a troubled borrower's loan is being extended. The Office of the Comptroller of the Currency (OCC) for banks and the Farm Credit Administration for Farm Credit also expand this tougher set of examination policies nationwide, so that regions and institutions not currently experiencing problems become subject to the same tougher examination policies. One of these standards will be shock testing portfolios at a more extreme level.
MORE CONTINGENCY PLANNING
In the near future, many farms may be required to provide the lender with the management succession plan and the current readiness of the successor to assume their duties should something happen to them. Also, with the increasing complexity and rate of change in agriculture, the division of responsibilities and strength of the management team will become more critical, and information on them, their tenure and expertise may also be required.
Evidence of and understanding of an integrated risk management plan and a description of counter parties on whom the operation is dependent will also need to be described. This would include the nature and requirements of any contractual arrangements. With some of the sustainability requirements set to be addressed due to the Farm Bill in future years, farmers will also require evidence of compliance and verification. Increasingly, lenders will likely be asking for interim budget performance reports, i.e., actual versus budgeted performance throughout the year with an explanation of any plans for corrective action or to modify the budget for the remainder of the year if negative variances are occurring. Larger problem loans will also need to provide evidence of compliance with the terms of loan agreements.
Given all these factors we're likely looking at several years of tighter credit. If a lending institution fails or gets in trouble and is acquired by another lender, farmers who finances with the former lender are almost always subject to higher credit standards. That's not because the new lender is tougher, but because the former lender was too lax. In the case where a farmer's loans were too large to be handled by the originating lender, a pull back by one of the participating lender(s) can be even more devastating, because there will be fewer, if any, lenders willing to take their place. Without a backup lender in place, big farm loans can become a house of cards.
EDITOR'S NOTE: Danny Klinefelter is a finance professor and economist with Texas AgriLIFE Extension and Texas A&M University where he teaches a beginning farmer program. He also is the founder of the mid-career Texas A&M management course for executive farmers called TEPAP. Grains Pro subscribers can access all of his columns online using the News Search feature under News.
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