Robust Agricultural Lending Sector Attracts Regulatory Scrutiny

WASHINGTON — While most lending sectors are still struggling to recover from the financial crisis, regulators are turning a nervous eye to one area that is thriving: agricultural lending.

As housing and commercial credit lies dormant, farm loans are rising, buoyed by skyrocketing property values in the agricultural industry. But rather than hold up the sector as a shining exception to the rest of the industry's malaise, the Federal Deposit Insurance Corp. is telling banks to watch out for another asset bubble.

"Everyone thought the increase in real estate prices in the housing and commercial real estate sectors was a good thing too until they collapsed," said Justin Barr, the managing principal of Loan Workout Advisers, a Chicago consulting firm.

Following an FDIC letter to banks last year urging strong risk management on farm loans, the agency is holding a symposium Thursday focusing on steps to get ahead of any agricultural downturn.

Bankers say a discussion about the risks from the booming sector is worthwhile. But they stress that institutions have learned from the last agricultural crisis, and are already de-emphasizing land values in their underwriting and encouraging hedging tools by borrowers to ease the impact of any farm downturn. They warn against the type of concentration limits regulators used to try to limit CRE lenders.

"That is the aspect of all of this that would concern the ag bankers, is if the examiners at the field level, despite whatever might be said in D.C., come into the bank and say, 'Well, you have too many ag loans.' In some communities, all you have is agriculture," said Mark Scanlan, the vice president of agriculture and rural policy at the Independent Community Bankers of America. "The focus really needs to be on the quality of the loan, not on an arbitrary determination."

The FDIC says farmland values have roughly doubled over the past decade. Adjusted for inflation, values have increased about 58%. Meanwhile, as total industry loans have decreased in all but two quarters since March 2008, farm loans have increased in eight of those quarters. Loans for farmland real estate have risen 98% over the past decade, to $68 billion. (Total loans for the industry during that period only rose 59%, to $7.37 trillion.)

"It's natural to ask: Is this boom going to lead to instability in the credit structure?" said Richard Brown, the FDIC's chief economist.

Brown said there are reasons not to fear a downturn like the crisis that hit agricultural banks in the 1970s and 1980s, and he acknowledged that concentrations are "a way of life" in agricultural communities. He said that the rise in farm-sector debt is nowhere near its acceleration before that past crisis, and banks' volumes of agricultural loans would not "lead us to immediately suspect a drop in [loan] quality."

Still, Brown said, the sustained growth in farm property values raises a red flag so soon after the mortgage debacle.

"You just want to make sure that the operators lending against those collateral values have an awareness of it, and we're not seeing the slipping standards either in the banking industry or outside the banking industry that would lead to credit problems down the road," Brown said.

"Once practices get out of hand … it's really too late. As early as possible, before there is a problem or before the problem is in the rearview mirror, is the time to be asking hard questions and raising some awareness."

As early as October, FDIC Chairman Sheila Bair was warning that farmland values could be the next asset bubble. Two months later, the FDIC's letter to institutions it supervises warned banks to expect fluctuations in now-rising commodity prices, employ detailed cash flow analyses in loan underwriting rather than relying on collateral and develop systems for workouts of troubled agricultural loans. (About 20% of FDIC-supervised institutions are classified as agricultural banks.)

While they acknowledge regulators are correct to focus on the extended growth, executives say agricultural banks are already ahead of potential concerns stemming from an eventual downturn.

"The ability that banks have today to run cash flow and asset price scenarios is stunning, and it can be done almost instantaneously," said John Blanchfield, the senior vice president of agricultural and rural banking at the American Bankers Association. "As a result I have almost unlimited faith in bankers' ability to weather any kind of hiccup in terms of asset values or cash flows."

For one thing, bankers note, loan-to-value ratios are considerably lower in farmland loans than other sectors, with agricultural producers typically putting down 40% of their loans.

"Agricultural banks took the experiences of the '80s and have fundamentally redesigned how we make ag loans, compared to how we used to it," said Matthew Williams, the president of the $110 million-asset Gothenburg State Bank in Nebraska. "We understand that repayment capacity is key. In the 1970s and '80s we were primarily collateral lenders. Now, that is certainly a factor, but more important is cash flow and ability to pay."

Williams, the ABA's vice chairman, said innovations common to agricultural producers also help hedge against industry threats such as weather catastrophes or declining commodity prices. The most well known is crop insurance, but biotechnology advances such as genetic engineering as well as the sale of options on future crop production also help mitigate risks.

"I've asked our loan committee and a lot of other bankers around: 'If you wake up tomorrow and land values have dropped 40%, what does this do to your bank?' " Williams said. "My answer from our bank is we would see a drop in many of our ag customers' net worth, but it would have little or no effect on loan quality in our portfolio. That is because of their income and cash flow, and the fact that their leverage position is so low."

Bankers said regulators would be wrong to assume there are parallels between the agricultural sector and the overheated CRE lending that was the driving force in so many community bank failures.

"We are trying to compare apples to oranges in a sense," Williams said. "But I do think the FDIC is correct in suggesting that we should be monitoring this risk."

Scanlan took exception to a part of the FDIC letter saying past guidance on CRE loan workouts "should be readily adapted" to agricultural loans. "We don't want to see a bright-line test" on agricultural loan limits, he said. "That would have some serious repercussions for ag lending that are basically not necessary."

But others are skeptical the agricultural finance sector has learned from past bubbles.

If institutions have learned from previous mistakes, "that would be the first time that ever happened in the history of banking," said William Isaac, who was the FDIC's chairman from 1978 to 1985.

"We keep on repeating these cycles. … I don't believe for a minute that we have learned and absorbed and forever more will be on alert about agricultural crises and bubbles."

Isaac, now the chairman of LECG Global Financial Services, agreed that concentrations of agricultural loans are inevitable at banks in rural communities, but that means "banks in those communities need to make sure that they maintain very strong capital ratios, good liquidity and they diversify their loans to the maximum extent possible, even perhaps selling portions of loans to banks in other areas, and swapping loan participations back and forth."

"It's an issue that at the very least we ought to be talking about and trying to decide just how serious it is," he added. "I wish more people had done that with the housing bubble, instead of just dismissing it."

Barr said while data on loan losses in the farm sector is still low, some indicators already suggest stress. He noted that as of Dec. 31 there was a nearly 78% year-over-year rise in farmland loans classified as "real estate owned," well above the increases in residential mortgages as well as construction and commercial loans. Still, the total REO for farmland loans was a comparably low $411 million.

The year-over-year increase in net chargeoffs for farmland loans was 43%, although the total net chargeoffs paled in comparison with other categories, Barr said.

"If you have a significant correction in commodity prices and interest rates go up, you could see significant devaluation in farmland prices," he said. "Banks just need to be cognizant of the very real risks here and structure loans accordingly."