What is in this article?:
- Farm real estate debt often plays a key role in farmland purchases. Without access to credit, many farmers and ranchers would find it difficult to buy land, especially with current values at historically high levels. Yet, extending too much debt could undermine the sustainability of lofty farmland values, and ultimately lead to a collapse in land markets.
Absorbing farmland value shocks
If farm borrowers’ debt repayment ability were to fall, agricultural lenders are well positioned to handle rising debt repayment stress. Since 2008, agricultural banks and the Farm Credit System’s profitability and capital levels have increased. However, depressed incomes in the livestock and biofuel industries have increased the number of nonperforming loans or nonaccrual loans. In response, lenders increased their loan loss reserves, especially agricultural banks.
Starting in 2008, agricultural lenders’ profitability fell. The global recession and financial crisis slashed demand for agricultural products. Falling demand reduced U.S. farm incomes as well as the profitability of agricultural lenders. While the Farm Credit System’s return on equity (ROE) held steady, agricultural banks saw a persistent decline in their ROE (Figure 3). Banks had a larger ROE decline because of their exposure to the 2008 struggles of residential and commercial real estate. Even though ROEs were down, they did not come close to their 1980s lows, especially the extreme negative ROE of the Farm Credit System in 1986.
As the global economy started to recover from the steep recession, so did the financial position of agricultural lenders. From 2009 to 2010, agricultural banks and the Farm Credit System saw their ROE rise about one percentage point. Much of this rise is attributable to 2010 net farm incomes rising 31 percent (USDA).
In addition to improvements in profitability, a rising capital position has bolstered the financial position of agricultural banks and the Farm Credit System. Since 1990, agricultural banks’ capital-to-asset ratio has been a fairly consistent 11 percent (Figure 3). The Farm Credit System’s capital-to-asset ratio, however, has fluctuated significantly over the same time period. Coming off of the 1980s farm debt crisis, Farm Credit increased their capital position to a peak of nearly 18 percent in 2004. But the Farm Credit System also increased their loan volume over 40 percent from 2004 to 2008, which contributed to their capital-to-asset ratio falling to nearly 12 percent. Today, Farm Credit has increased their capital-to-asset ratio to just over 14 percent, which has improved their financial position.
While Farm Credit and banks appear to be well capitalized, nonaccrual loans have increased, prompting lenders to increase liquidity levels. In 2009, nonaccrual loans rose over 40 percent (Table 1). This rise is largely attributable to falling livestock incomes, especially dairy and poultry incomes, as well as strained profits for ethanol related loans. If these rising nonaccrual loans eventually lift net charge offs, agricultural lenders could be stressed. One way to mitigate this stress is to increase liquidity levels. Farm Credit and agricultural banks have done so by raising their loan loss reserves—their provisions to cover potentially bad debts.
Compared to the Farm Credit System, agricultural banks appear to be in a stronger liquidity position to cover nonaccrual loans should these loans default. One way to assess if loan loss reserves are adequate to cover potentially bad debts is to calculate a coverage ratio. The coverage ratio divides loan loss reserves by nonaccrual loans. In general, a coverage ratio above one means the lender has adequate reserves to cover potential losses. Agricultural banks’ coverage ratio is well above one, while the Farm Credit System’s coverage ratio has dropped to 0.42. The Farm Credit System’s coverage ratio fell below one because their nonaccrual loans are rising much faster than their provisions to cover the potential that these loans are charged off. While this could be problematic for the system, their increasing capital-to-asset ratio, as shown in Figure 3, provides cushion against nonaccrual loans that could be charged off.
In fact, agricultural lenders are well positioned financially to withstand a decline in farmland values today. Admittedly, trying to predict the impact of falling farmland values on a lender’s farm loan portfolio is difficult (Gustafson, Pederson and Gloy, 2005). However, this does not mean stress testing lenders’ farm loan portfolios is not worthwhile. In fact, economic models analyzing the relationship between net loan charge offs and farmland value declines find that if farmland values fell 3.5 percent, net loan charge offs could rise 0.2 percent (Briggeman, Gunderson, and Gloy, 2009). In turn, if net loan charge offs rose 0.2 percent at agricultural banks and the Farm Credit System, bad debts at both institutions would rise $243 million and $350 million, respectively. While both lenders have sufficient loan loss reserves to absorb this shock, agricultural banks have enough reserves that there coverage ratio would not fall below one.