Financial Crisis: How It Happened, Why Agriculture Is in Better Shape

By Jane Fyksen Crops Editor
Thursday, November 20, 2008 7:36 AM CST

Producers, like other Americans, are worrying and wondering how to manage their incomes in the midst of a worldwide financial crisis. They’re likely also scratching their heads and asking: So how exactly did we get here?

Nick Paulson, University of Illinois economist, says the simplest answer is: Too many bad mortgage loans over the past few years.

In the good old days, mortgage lending was done through “local” savings and loan institutions that loaned money directly to people within their communities. Traditional mortgage terms typically included a fixed interest rate over a fixed term and required a significant down payment from the borrower to provide sufficient collateral even if real-estate values decline.

Over the last 30 some years, debt owned by traditional savings and loan institutions has declined, while total mortgage debt held by non-local parties n through the use of asset-backed securities n has increased significantly. “These securities are created by pooling a large number of mortgages together for sale to investors who are then n theoretically n paid a return over time using the stream of mortgage payments from the borrowers,” Paulson reports.

However, recently, relatively low interest rates and loose credit availability created a boom in U.S. real-estate markets. Demand for home mortgages increased significantly and mortgage brokers (driven by profits determined by commissions) came up with “creative ways to make loans available to a larger pool of potential borrowers,” Paulson continues, noting that from 1995 to 2007, total mortgage debt in the United States went up from $3.5 trillion to over $11 trillion.

A rapid rise in real-estate values provided “justification” for loans in excess of market values, without in many cases, down payment requirements and/or documented proof of repayment ability. “Originating lenders were more than willing to approve loans to even the riskiest borrowers, because they never intended to personally finance and take on the risk of the mortgages. This was done by the buyers of the mortgage-backed securities,” he explains.

In 2006, “the party literally started to end,” he continues. Many of the existing non-traditional mortgage contracts became unaffordable to borrowers as variable interest rates adjusted upwards and balloon payment on no-interest loans came due. At the same time, housing values began to fall, so that the collateral upon which individual mortgages and pooled securities were based n the value of the homes themselves n weren’t sufficient to cover outstanding loan balances. Paulson says it’s estimated that at least 15.4 million U.S. homeowners (roughly 30 percent) will have zero or negative equity in their homes by the end of this year.

The value of mortgage-based securities has plummeted as default rates rise and investors shifted their money out of increasingly risky debt-based instruments into safer investments. That led to the failure of large investment institutions and the current credit crisis, which is ultimately driving by a “lack of liquidity,” he states.

Investors are wary of putting their money at risk in debt markets, which made it exceedingly difficult for lenders to obtain financing needed to originate new loans or lines of credit n even to credit-worthy borrowers. The federal government’s $700 billion bailout plan will supposedly help alleviate liquidity problems.

What about agriculture?

Paul Ellinger and Bruce Sherrick, also University of Illinois economists, say ag lenders are generally in stronger financial health, as most didn’t participate in the higher-risk housing lending like larger urban banks, nor were they substantially invested in the structured securities that lost substantial market value. Most ag lenders haven’t incurred the huge losses of the Wall Street banks.

What’s more, compared with other sectors of the economy, agriculture uses a lower amount of debt relative to assets. USDA estimated total farm debt at the end of last year to be around $211 billion. Total farm sector assets exceeded $2.2 trillion, resulting in a farm aggregate debt-to-asset ratio of only 9.6 percent.

Agriculture’s primary lenders are commercial banks, the Farm Credit System, insurance companies, the Farm Service Agency and captive finance companies.

These two say the Farm Credit System holds about 42 percent of real-estate debt and 31 percent of non-real-estate farm debt. Commercial banks have the highest market share of non-real-estate farm debt (53 percent), while lending 38 percent of farm real-estate loans.

Commercial banks lending to agriculture are generally small, community banks that use local deposits as their primary source of funds. “As a group, they have fared relatively well,” this pair reports, adding that over 78 percent of the volume and over 93 percent of the banks are less than $10 billion in asset size. About 18 percent of banks lending to agriculture are publicly traded or owned by a publicly traded bank holding company.

While community banks are, as noted, a significant lender to agriculture, there remains some exposure to the issues facing larger banks through the remaining market share. The largest 15 banks lending to ag hold about 20 percent of total farm debt. These, say Ellinger and Sherrick, have been exposed to the financial stresses occurring in the credit markets. “Hence their agricultural activities are not likely insulated from the effects of the current financial market disruptions either,” they say.

They note the strong capital positions of the smaller institutions lending to agriculture. Only 13 of 6,071 banks lending to ag were recently undercapitalized by FDIC.

All in all, they say the “general health of commercial banks lending to agriculture remains strong, especially given the government’s increased support of deposits and infusion of capital for larger institutions.”

The Farm Credit System associations have generally strong balance sheets and have experienced recent strong profitability, these experts continue. “The capital positions and credit quality of the banks and associations remain strong through this economic downturn. However, the rapid recent growth of volume and concerns about capacity for future growth without undue capital dilution have greater concerns than losses from either the credit or investment exposure with Farm Credit System institutions,” they say.

Farmer Mac, which serves as the secondary market for ag loans, did maintain a substantial investment portfolio and suffer substantial capital losses due to investments in Fannie Mae, Freddie Mac, Lehman Brothers and similar securities. As a result of exposure to these positions, preferred stock was issued to increase effective capital ratio. The motivation for the recapitalization wasn’t due to problems with the quality of the ag loan portfolio but “due to exposures to positions largely viewed as high-quality investment grade bones just a couple months earlier,” they say.

These University of Illinois experts say these are “truly unprecedented times” in the U.S. economy. However, “it is clear that in general, the financial health of agricultural lenders remains strong,” they say, noting that ag lending is also characterized by strong customer-borrower relationships. Lenders are apt to be concerned about the current economic downturn and the profit margins of their producer/borrowers. Another concern is the impact that shrinking margins will have on land prices n and, again, the financial health of their borrowers.

Ellinger and Sherrick say lenders will be “cautious.” Similarly, producers should “certainly discuss any concerns you have about the financial performance of the institution with the management of your institution…you should be comfortable with your financial partner.”

For historical financial performance of your bank visit www4.fdic.gov/IDASP/. Farm Credit System institution financial reports can be viewed at https://reports.fca.gov/CRS/search-institution.asp. The FDIC has a tool you can use to determine your insurance coverage at www4.fdic.gov/EDIE/.

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