The responsible lending practice of the agricultural lending industry
The current financial losses suffered in the residential lending industry are in part attributed to the overzealous loan products that were available, e.g. the abusive lending practices of the subprime, Alt A and even high loan to values of conforming loan products. When a lending industry does not give sufficient consideration to the repayment capacity of the borrower, the industry is essentially doing what is called “equity lending.” The loans are based on the market value of the security property and the expected future appreciation on the market value. As we have seen recently in the residential sector, values will not always be on the rise and an economic downturn starts a downward spiral in real estate values and correspondingly capital loss to investors.
The agricultural lending industry learned this very painful lesson in the mid 1980’s. In the 1970’s and early 1980’s, agricultural lenders did equity lending to farmers. This is seen on the accompanying USDA graph depicting the debt to asset ratio of farms nationwide from 1950. The D/A ratio peaks in the mid 1980’s and decreases steadily thereafter. During this period of equity lending, agricultural lenders did not sufficiently analyze the cash flow repayment ability of the farming operation. Loans were given on the basis of the market value of the farm real estate, which was appreciating, and the potential increase in the future market value. Sound familiar? The consequences that came to fruition in the mid 1980’s were similar to what we have seen in the residential sector currently, only on a smaller scale, a rise in default rates and the subsequent foreclosures of farms. In fact, the federal government bailed out traditional agriculture lenders to the tune of billions of dollars.
The good news is that since the 1980’s the agricultural lending community has incorporated into their lending models sufficient emphasis on the cash flow repayment of the security property alone and the overall farming operation. These responsible lending practices are a major contributing factor to the current underlying fundamental strength of the agricultural sector. Namely, that the land value of farm real estate is not allowed to get out of proportion to the economic profitability of the commodities grown. For example, if a farmer is attempting to purchase a farm in which the value of the real estate is greater than the commodities ability to generate profit/debt service repayment, the lender will either lower the loan to value to an acceptable level or deny the loan request. These responsible lending practices have to a large extent, prevented volatile swings in land values and buffered traditional production cycles common to the agricultural sector.