The farm financial crisis of the 1980s was ugly. Few people in farm country passed through that period without learning some painful lessons. One banker summed up the experience as “living in a world of hurt.”
Bankers, questioned about the sharp rise in farmland prices over the past couple of years, stress the conservatism burned into the minds of both producers and lenders who had been through the crisis. They also note that price trends are spotty and that many recent land purchases have been for cash. Nevertheless, questions persist about the potential for another ag land bust.
Is there a price bubble? If so, what would cause it to burst? And if that happened, what can banks do?
Plowing deep into the numbers
Dr. Allen Featherstone, professor of agricultural economics at Kansas State University, Manhattan, Kans., and a scheduled speaker at ABA’s National Agricultural Bankers Conference this month, has been studying the possibilities. In a recent paper, Leveraging the Farm, and in answers to questions from ABA BJ, Featherstone makes a case for caution, but also for cautious action.
Featherstone has studied various databases, one of them the historical performance of the loan portfolio of Equitable Agribusiness during the 1980s. He found this telling point:
“Even in the worst time to be lending in the last bust, only about 10% of the loans made during that period did not make it. . . . But that 10% caused havoc in the system.”
In his research, Featherstone found that there are some ag observers who take comfort from the average probability of default for loans made during a given period. Looking at Kansas Farm Management Association farm figures, he found that the average probability of farm borrower default fell by the end of 2012 to 1.54%—the lowest level since 1974 (1.45%). In 2002, the level was 2.9%. However, he points out in his research that higher risks of default exist within the averages. These “tails” in the distribution of default risks indicate vulnerability.
“That vulnerable tail can be a driver of falling land values as farmland is released to the market to be purchased by other farmers,” he writes.
Commenting on the numbers, Featherstone warns that “looking at averages can lead to a sense of complacency, regarding beginning to see potential issues arising. It is important to look at the marginal borrowers in the portfolio and see how they are doing. Asset markets are relatively thin, and detecting how those more marginal borrowers are performing can provide insight into where the market could be headed.”
His research points out that, “the average default probability is less in 2012 than it was in 1979, [but] the percentage of farms with lower credit quality is roughly the same at the end of 2012 than it was in 1979. The quality of credit can change quickly.” He pointed out that the 4.3% of farms with less than a B rating in 1979 grew to 16.2% of farms in 1981.
Is leverage a problem?
In his paper, Featherstone examines farmers’ leverage to see if it is currently a potential cause of a bust. Drawing on several statistical databases, he concludes: “The farm sector is currently in excellent shape from a leverage and credit perspective. Leverage will likely not be the cause of a bust cycle, but it certainly can exacerbate the falling of land values.”
A point he made in answering an ABA BJ question is that many of the factors influencing the state of land prices work on each other as well as on the whole picture.
“In general, banks and farmers are being fairly conservative,” says Featherstone. “I think the real thing to think about is the secondary effects that an increase in interest rates could have on the market. An increase in rates would also likely strengthen the dollar. The strengthening of the dollar will make U.S. exports more expensive than those of South America. Thus prices on U.S. products would need to fall further to move commodities globally.”
“I am not sure how well our stress testing is shocking for multiple things that tend to be correlated,” Featherstone goes on to explain.
Impact of interest rate increases
The bust of the 1980s began, Featherstone recounts, when farmers experienced a drastic fall in their ability to repay loans because of a drop in income due to falling prices and increasing interest payments.
Any increase in interest rates now will be cause for potential concern, according to Featherstone. However, “the issues are how fast an increase would occur and the time it would take for the economy to adjust.” A gradual increase in rates would be absorbed better in the ag land markets than a rapid rise. Typically, he explains, 2% to 3% of land changes hands annually.
“A rapid increase in rates would have the ability to put the supply of land on the market out of alignment with demand,” says Featherstone. “If rates increased quickly, a doubling of land on the market could move prices downward very quickly.”
There would be ripple effects as well. A rapid rise in rates could panic those farmers who are nearing retirement age, Featherstone suggests. They could decide to bail out of the market by selling out while they can preserve as much value as possible. “Then the land market could get out of equilibrium,” says Featherstone.
Another potential impact of rising rates could come from older landowners who no longer work the land, but rent it. Right now, the arrangement pays, but if rates increase, these landowners may be tempted to liquidate land and move into CDs or Treasuries, putting more land on the market and causing a further decline.
Impact of other economic factors
It can be argued that the agricultural economy may be better insulated now from rate and other issues than it was in the late 1970s due to the use of fixed interest rate debt and crop insurance.
Featherstone examines the price protections that the government programs provide to farmers. Time lag between the risk and the safety net concerns him. So does the amount of protection that eventually would be delivered.
“The issue that I worry about most, at this point, is a couple of bumper crops around the world,” says Featherstone. He presents the following scenario of concern.
A price drop, triggered by a significant supply jump, would cause government program support to kick in, but not right away. “By the time the programs would provide income support, some in the sector would be in trouble financially,” he says.
“Crop revenue insurance is also believed to be a safety net,” says Featherstone. “However, the prices of those contracts are reset each year based on futures market prices for the upcoming crop.”
In 2012, he explains, the price for corn for revenue insurance was $5.64 per bushel. At price levels in late October, he continues, corn for December 2014 is trading at a price that would set the guarantee at $4.72.
If those numbers hold, Featherstone says in warning, “the floor for insurance has dropped by 16.5%. With a bumper crop, that could drop further.”
“The protection comes from the impression that crop insurance provides a floor,” says Featherstone. “It does really well with a yield drop. If the prices drop, the floor moves downward very quickly. From 2013 to the 2014 crop, the floor will likely fall on crop insurance policies by more than 15%.”
Regarding the point about fixed interest rates, Featherstone notes that about half of current farm debt carries floating rates. He also points this out: Adjusted for inflation, the average real cost of defaulted mortgages in the last bust was 2.41%; currently, the comparable average real cost of borrowing is 3.59%.
What can ag banks do?
Early warning and early monitoring of those borrowers who are most likely to default, given their credit position, makes a good effort to protect banks, says Featherstone. “I think the lending community has been doing a pretty good job insulating itself up to this point,” he observes. Vigilance is important because in the last bust cycle, defaulted loans performed for 5.6 years, on average.
Another area to focus on, advises Featherstone, is tracking borrowers’ repayment of operating credit.
“Deteriorating repayment of short-term credit will likely be one area that would begin to show up if the sector begins to get into trouble,” says Featherstone. “I am not sure that a bank can totally insulate itself, but having a plan to monitor credit condition and to respond to those that show deterioration can help to mitigate any damage.”
Featherstone expects that if land values begin to fall, bankers will tend to back off on existing credit.
However, he suggests a somewhat contrarian strategy. When values begin to fall, “that may be the time to look at making credit available to those farmers who are in relatively strong financial condition, such that there will be demand for land,” Featherstone explains. “Locking credit in a declining market to all borrowers has the potential to further push a land market out of equilibrium, if suddenly potential buyers become credit constrained.”