The Changing Financial Environment

The trend toward a farm sector composed of a large number of small, part-time farming operations and a much smaller number of large commercial farms will continue. Agricultural lending is also undergoing major changes in order to service these two distinctly different classes of farms.

Farms relying primarily on off-farm income for repayment ability will be handled primarily as consumer borrowers. These loans will be subject to fairly standardized rules based on percentage of income devoted to debt servicing, overall debt-to-asset ratios, and specific collateral margin requirements.

Large commercial farms will be viewed as agricultural businesses and handled much like other commercial loans. They will be subject to more information and documentation requirements, increased emphasis on repayment ability, and longer run general economic and specific enterprise outlook analysis, particularly for term loans. Compared to traditional farm loans, these loans will require the managers of these commercial farms to develop much more sophisticated business plans and management information systems to track total farm as well as specific enterprise performance.

Lenders will also place increased emphasis on a better balance between equity and debt funding. More of the commercial farms will be vertically integrated, involve multiple ownership, and be more heavily involved in the leasing of farm machinery and other assets. Loan analysis will be more sophisticated than in the past.

Basis for Changes in Lending Decisions

Increased emphasis on repayment ability and risk analysis will affect the availability of agricultural credit more than the supply of loanable funds. Dramatic changes have already occurred, but even with all that has been said and written about cash-flow requirements, the analysis of repayment capacity is still in its infancy. While many agricultural lenders have improved their written loan policies, there remains a significant gap between policy and practice.

Until recently, many agricultural lenders based their loan decisions primarily on their knowledge of the borrower, the borrower's past repayment record, the borrower's financial position, and the adequacy of collateral margins. While these are still necessary and important, they are not the only considerations for a sound loan.

Balance sheet or collateral-based lending has two major weaknesses: (1) it considers only the protection of the lender; that is, it does not address whether the loan will benefit the borrower, and (2) its primary underlying consideration has been the expected recovery value of the collateral at the due date of the note or at the date of the next scheduled payment. Therefore, there has been a tendency for lenders to be more liberal, resulting in excessive borrowing when asset values are appreciating, and excessively conservative when asset values are declining. This practice has resulted in large numbers of borrower failures and loan losses whenever asset values have taken a sharp downturn. In the future, more emphasis will be placed on repayment ability, with collateral being viewed in its proper role of providing insurance and control, not as the justification for lending or borrowing.

More Than Cash-Flow Analysis Needed. Many lenders and farmers limit their analysis of repayment ability to examining annual cash-flow projections. Projected annual cash-flow is an important element of repayment ability, but it is strictly a short-run analysis. A business can be going broke and still generate a positive cash-flow for several years by reamortizing debts, selling off assets (including inventories), and not replacing capital assets as they wear out (living off depreciation). Moreover, because cash-flow projections are based on expected values, the actual outcome is subject to considerable uncertainty. Not enough effort has typically gone into evaluating the impact of alternative possible outcomes. Even in those cases where an attempt has been made, it has usually involved evaluating some standard scenario such as a 10 percent or 20 percent decrease in revenues. This is a first step, but does not account for performance history or the risk inherent in an individual business.

The frequently neglected half of repayment capacity has been the evaluation of historical and projected profitability on an accrual basis. Cash-basis income accounting can lead to lags of as much as 2 years in recognizing developing profitability problems. The reverse is also true: cash-basis accounting delays recognition of profits during growth periods when the problem may be more liquidity than profitability. Occasional or periodic losses can be tolerated, but negative income trends need to be a major consideration in any sound financial program.

Another problem has been the lack of consistently prepared information based on something at least approximating generally accepted accounting principles. In too many cases, agricultural credit analysis is based on data which can be fairly described by the phrase "garbage in garbage out." Many lenders still do not require balance sheets for both the beginning and end of the period for which income is measured; instead, they go through a series of numerical gymnastics in an attempt to reconcile the changes in net worth during the period. Lenders will increasingly require farmer borrowers to provide financial statements as of the end of the accounting period. Most other types of business borrowers already face this requirement.

Other needed changes include the development and implementation of standards for evaluating key financial position and performance indicators for different types of farms. To the extent that rules of thumb now exist, they are usually generic, and not very useful in comparing a dairy operation with a grain farm, for example. At some point in the near future, industry standards will be developed for different types of farms similar to those now used by nonfarm businesses. Currently, lenders are a long way from getting the information needed to analyze the performance of different enterprises, both within and among firms.

Restructuring the Farm Credit System

Two areas of restructuring will have the greatest impact. The first is the merger of unlike entities. This includes not only the existing single Farm Credit Bank in each district, but also the merger of Federal Land Bank Associations (FLBA's) with Production Credit Associations (PCA's) to form Agricultural Credit Associations. Both units are direct farm lenders and, except for tax purposes, there are questions as to how much sense it makes to have separate corporate entities who, in some cases, are competing with each other. At the association level, merging lending functions helps not only with marketing and account servicing, but also with loan structuring and control. In addition, mergers can reduce unnecessary duplication and consolidate capital.

The second area involves district mergers, and its outcome is less clear. While there are obvious economic advantages, there are potential disadvantages and more political resistance at the local level. Yet, in many cases district mergers make sense. Improved communication technology, fewer associations, and the shifting of examination responsibilities to the Farm Credit Administration also reduce the need for the current number of districts. To the extent the secondary market for farm real estate loans ("Farmer Mac") is successful, it is unlikely that the Farm Credit System will regain the market share it once had. There are also economies of scale in fund raising, risk management, purchasing, applications of technology, and so forth. Another advantage is the ability to diffuse geographic based politics on district boards.

The most obvious disadvantage is short run, but very real. Reorganization tends to be disruptive both to employees and borrowers each time it occurs. There is a learning curve and an acceptance period involved which no amount of economic logic can eliminate.

Whatever happens at the district level, there will continue to be a physical downsizing in the field. There simply is not the need or economic justification to maintain the current number of field offices, particularly in districts where the PCA's and FLBA's are consolidated. There will also be a continuing merger of associations into larger units and a movement toward maintaining offices only in agricultural trade centers.

Differential Loan Pricing. This will be a major factor in determining the extent to which the Farm Credit System will be able to serve the emerging commercial farming sector. Unless the system begins to competitively price loans to borrowers who qualify for preferred rates with other commercial lenders based on their lower risks and servicing costs, it will be priced out of the market for the most creditworthy borrowers. This will, in turn, cause higher rates for remaining borrowers. The issue of equity versus equality has long been a problem for most cooperatives, and the longer a cooperative retains the traditional concept of equal pricing, the more the market will tend to reward it with fewer of both the bigger and the stronger customers. Differential loan pricing benefits all borrowers, a fact not well understood by some borrowers paying higher differential rates. By lowering the operating expense rate, increasing profits, and lowering overall portfolio risks, the rate charged to the more marginal borrowers will be lower than if the preferred customers move to other lenders.

Commercial Bank Adjustments

The commercial banking system is also in the midst of some major structural changes, and nowhere will these changes be more evident than in rural agricultural banks. The establishment of regional loan production offices by major banks and the accelerating movement toward statewide and interstate banking will change the competitive situation in many agricultural markets. Twenty years ago, banks with less than $25 million in assets held 70 percent of bank farm loans. Today, that group holds only 18 percent of these loans. Over the last decade, those banks classified as nonagricultural, but which hold more than $2 million in farm loans, have become the most important group of banks financing agriculture, and their importance is increasing.

A large number of independent rural banks are going to go the way of automobile and implement dealerships in small towns across the country. Many of these primarily agricultural banks suffer from a shrinking local retail base, growing competition for their best agricultural borrowers, and limited diversification of their loan portfolios. In the Southwest and parts of the Southeast, problems were compounded in areas where the economy was also heavily dependent upon the oil and gas industry. The combined slump of energy and agriculture adversely affected these banks almost as much through the multiplier effects on the local economy as through direct loan losses. In primarily agricultural areas, the survival of these banks will depend largely on the extent of their participation in Farmers Home Administration (FmHA) subordination and loan guarantee programs. In most cases, these banks will not be attractive acquisition targets for the larger banking systems, since the bigger banks do not need local physical facilities to reach the commercial market they are after.