Present financial position and performance of the firm



Handout #6

Agricultural Economics 489/689

Financial Intermediation and Ag Lending Institutions

Spring Semester 2009

A. Financial Intermediation

The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment.

There are numerous lenders providing loan funds to agriculture and related businesses. Commercial banks are one of these lenders, and are a financial intermediary in the truest sense of the word. They make loans using the deposits of lenders in addition to originating loans and selling them in secondary markets.

Other lenders obtain loanable funds in other means. The Farm Credit System sells consolidated system-wide bonds in the government securities market. Life insurance companies use funds collected on policies (insurance premiums), the Farm Service Agency uses funds appropriated by Congress, and lenders like John Deere Credit use funds appropriated by the parent company.

B. Financial Institutions

Farm Credit System

The seeds of the Farm Credit System were planted by President Theodore Roosevelt in 1908, when he appointed a Country Life Commission to address the various problems facing a predominantly rural population.

At the time, agricultural real estate loans from commercial banks, if they were available at all, had prohibitively high rates and short terms. Until 1913, for instance, federal law prohibited national banks from making loans with maturities beyond five years.

The commission's report documented a lack of any adequate agricultural credit, whereby a farmer may readily secure loans on fair terms.

The report led to various presidential and congressional studies over the next several years, which included extensive analysis of other nations' rural credit systems.

The credit delivery method established by the 1916 Federal Farm Loan Act was based largely on Germany's Landschafts, which had operated since 1769 and appeared to be the most successful of the various European cooperative ag-credit systems.

During the pivotal congressional debate over an American agricultural credit system, nearly 100 different bills were introduced, which ultimately focused on three major approaches:

• Small, independent land banks, with federal charters but private capital. Proponents of this concept favored the non-government funding, but critics feared its built-in motive for high profits would not assure low rates to farmers.

• Twelve federal land banks owned by their farmer-borrowers, partly capitalized by the government and financed through the private purchase of tax-exempt bonds. Advocates maintained this cooperative structure would guarantee low rates, but critics disliked the government sponsorship and expense involved.

• Direct government loans to farmers, favored by the nation's farm organizations but opposed by most politicians.

Congressional proponents of these three approaches battled to a stalemate in 1914, which led to the creation in 1915 of a Joint Committee on Rural Credits, which in turn drafted the final compromise that was adopted in 1916.

Lawmakers chose a cooperative credit structure based on 12 Federal Land Banks (FLBs), using $125 million in government seed money but financed by private capital from investors.

One sidelight of the Farm Credit legislation is that it helped lawmakers prepare themselves for more sweeping financial legislation. The chairman of the Joint Committee on Rural Credits was Rep. Carter Glass of Virginia, who teamed up a few years later with a colleague on the House Banking Committee, Rep. H.B. Steagall of Alabama, to write the Glass-Steagall Act of 1933 the basic legal structure for most of the nation's commercial banks.

The Early Years: Creation of the Farm Credit System coincided with World War I, a very prosperous time for American farmers with the demand for food in Europe. But prices collapsed after the war, and among the resulting economic problems were severe shortages of short-term credit for farmers.

Congress responded with the Agricultural Credits Act of 1923, adding 12 Federal Intermediate Credit Banks (FICBs) to the Farm Credit System. However, these were flawed by procedural and geographic problems, and a long and complicated loan approval process.

Things went from bad to worse with the stock market crash of 1929, touching off the Great Depression, throwing thousands of farmers into foreclosure and virtually shutting down the System's ability to finance agriculture.

Three major agricultural laws followed that would lead to a sweeping reorganization of the Farm Credit System:

• The first was the Agricultural Marketing Act of 1929, enacted to help stabilize farm prices and finance the development of agricultural cooperatives (which had been authorized by the Capper-Volstead Act of 1922).

• In 1933, Congress passed two crucial laws affecting the future of Farm Credit. One was the Emergency Farm Mortgage Act, which recapitalized the land banks with $189 million and cut interest rates to deal with the Depression.

• The other was the Farm Credit Act, which, among other things, revamped the FICBs and established a new production credit system for farmers and ranchers through local Production Credit Associations. The Act also created 13 Banks for Cooperatives.

• President Franklin Roosevelt also issued an executive order in 1933 consolidating the supervision of all the federal agricultural credit agencies under the new Farm Credit Administration.

• These various cooperatively owned financial entities, with the FCA as their regulator, formed the basis of the Farm Credit System as it exists today.

Post-World War II Prosperity: During and after World War II, prosperity returned to American farmers. The decade of the 1950s saw technology transform agriculture, and also marked a major period of growth for the Farm Credit System.

Various laws were passed during this period which modified the directorship arrangement of Farm Credit institutions as well as the structure of the FCA, and pushed the System towards full ownership by its farmer/rancher-borrowers.

The System began a campaign in 1940 to pay off the government capital investment, a goal the Land Banks achieved in 1947. The Banks for Cooperatives and the last of the PCAs followed suit in 1968, leaving the Farm Credit System with all federal capital repaid and completely owned by its borrowers.

With its government capital paid off, a National Services Commission on Agricultural Credit was formed in 1969 to consider where the Farm Credit System should head in the future. Its recommendations formed the basis for the Farm Credit Act of 1971, the most sweeping update of the System's charter since 1933.

The 1971 act, along with amendments added in 1980, significantly expanded the range of services Farm Credit institutions could offer, to include rural home mortgages, leasing services, international and rural utility lending. It also expanded certain authorities of local associations, and led to a major reorganization of the Farm Credit Administration.

Financial Stress in the 1980s: As agriculture plummeted into recession in the early and mid 1980s, Farm Credit predictably suffered severe financial stress. During a three-year period from 1985-1987, Congress passed several laws to deal with recessionary economic and agricultural conditions.

After this devastating period of rising inflation and collapsing farmland values, the legislation of the mid-80s made several major revisions to the structure and operations of the Farm Credit System and provided financial assistance in the form of a fully repayable, privately financed line of credit which was guaranteed by the federal government. As a result of the Congress' efforts:

• Farm Credit Administration became a fully independent arm's-length regulator;

• A limited and temporary government-guaranteed line of privately financed assistance was provided to stressed System institutions;

• Risk-based capital standards were mandated, to be determined by FCA;

• The Farm Credit System Insurance Fund was created, financed by annual contributions from System banks; and

• The Federal Farm Credit Banks Funding Corp., which manages the sale of Systemwide securities, was formally established by statute as a System entity;

In addition, a major consolidation of System institutions was undertaken. In the early 1980s, the Farm Credit System was comprised of 37 banks and more than 1,000 local lending associations. Today, there are only 6 Farm Credit System banks and a little more than 200 local lending associations.

As the 1980s drew to a close, and agricultural producers began their recovery from the recession, Farm Credit began its return to financial health a trend that continued and strengthened into the '90s.

Recent Years: In 1990-1991, Congress asked Farm Credit to play a greater role in financing agricultural marketing and processing operations, as well as water and sewer loans in rural communities.

In 1992, Farm Credit petitioned the Congress to enact legislation allowing Farm Credit to repay in advance, the financial assistance provided in 1987. As a result, the Congress enacted the FCS Safety and Soundness Act. The 1992 law clarifies the Farm Credit System's obligation and makes provision for full repayment of all the assistance borrowed, including interest. These developments ensure the System will have repaid all its financial assistance, without any cost to the government.

That same year, all System banks met or exceeded the new 7 percent risk-weighted permanent capital standard mandated by FCA -- an achievement that came nearly a year ahead of schedule.

The System continued to show strong profits throughout the early 1990s. As a result, the last of the four Farm Credit Banks that received financial assistance due to the 1980s recession redeemed its assistance -- almost 10 years before the 15-year assistance bonds are due.

The 1990s also have seen a continuation of trend toward consolidation in Farm Credit, as the first Agricultural Credit Bank was formed by the merger of a Farm Credit Bank and two Banks for Cooperatives. Consolidation is expected to continue.

The Farm Credit System (Farm Credit) is a nationwide network of borrower-owned financial institutions and specialized service organizations. Farm Credit consists of five Farm Credit Banks that provide funding and affiliated services to approximately 100 locally owned Farm Credit associations and numerous cooperatives nationwide. The fundamental purpose of this network of Government-sponsored enterprises created by Congress in 1916 is to provide American Agriculture with a source of sound, dependable credit at competitive rates of interest. Farm Credit provides credit and related services to farmers, ranchers, producers and harvesters of aquatic products, rural homeowners, certain farm-related businesses, agricultural and aquatic cooperatives, rural utilities, and to certain foreign or domestic entities in connection with international agricultural credit transactions.

Farm Credit provides some $103 billion in loans to more than a half million growers, agribusiness and agricultural cooperatives, electric and telephone cooperatives, and rural utility and water systems. Overall, more than 30 percent of the credit needs of U.S. agriculture are met by Farm Credit institutions.

Today, Farm Credit institutions are organized as cooperative businesses, each owned by it's member-borrow stockholders who have the right to participate in director elections and vote on issues affecting the institution's operations.

Life Insurance Companies

One of the major life insurance companies providing loan funds to agriculture is Prudential Life Insurance Company. Prudential Agricultural Investments, a specialized unit of Prudential Mortgage Capital Co, supplies medium to long-term mortgage-based loans for a wide range of agricultural properties. With an approximately $2.0 billion agricultural mortgage portfolio, it has a rich history of experience in agriculture.

Prudential is proud of its heritage serving the mortgage needs of family farms, ranches, agribusiness, and timberland owners for more than 100 years. It meets the unique needs of individual landowners or large agribusiness firms in several ways. Backed by one of the largest and financially solid institutions in the nation, it can:

• Provide a variety of agricultural loan products and create mortgage solutions in shapes and sizes designed to fit customer needs either directly or through its AgMap network.

• Cover a wide range of agricultural properties and land uses including annual crops, permanent plantings, ranchland, timberland, and agribusiness facilities.

• Stay abreast of issues facing the agricultural and forest product industries today, to blend the lessons of the past with opportunities for the future.

• Help customers create innovative financial solutions necessary to maintain future viability of their agricultural enterprises.

• Work closely with the professional staff in Prudential’s farm management and real estate subsidiary.

Prudential offers competitive mortgage financing solutions for new acquisitions, expansion and improvements, or re-financing existing debt for qualified borrowers seeking:

• Fixed-rate, long-term (5-20 years) mortgage loans secured by agricultural land.

• Adjustable-rate or variable-rate loan products from 1-5 years (amortized long term).

• Flexible financing structures to meet your specific needs. Minimum loan size is $500,000.

• Total lending capacity up to $100 million per customer.

Prudential works with a wide range of agricultural property types to secure agricultural loans:

• Annual crops, including row crops, grains, cotton, and forage.

• Permanent plantings, including orchards & vineyards.

• Ranchland, including improved pasture and rangeland.

• Timberland, including commercial forests in the Pacific Northwest or southeast.

• Agribusiness facilities, including processing, packaging, & storage facilities.

Commercial Banks

The banking industry is a highly regulated industry with detailed and focused regulators. All banks with FDIC-insured deposits have the FDIC as a regulator; however, for examinations, the Federal Reserve is the primary federal regulator for Fed-member state banks; the Office of the Comptroller of the Currency (“OCC”) is the primary federal regulator for national banks; and the Office of Thrift Supervision, or OTS, is the primary federal regulator for thrifts. State non-member banks are examined by the state agencies as well as the FDIC. National banks have one primary regulator—the OCC.

Each regulatory agency has their own set of rules and regulations to which banks and thrifts must adhere.

The Federal Financial Institutions Examination Council (FFIEC) was established in 1979 as a formal interagency body empowered to prescribe uniform principles, standards, and report forms for the federal examination of financial institutions. Although the FFIEC has resulted in a greater degree of regulatory consistency between the agencies, the rules and regulations are constantly changing.

In addition to changing regulations, changes in the industry have led to consolidations within the Federal Reserve, FDIC, OTS and OCC. Offices have been closed, supervisory regions have been merged, staff levels have been reduced and budgets have been cut. The remaining regulators face an increased burden with increased workload and more banks per regulator. While banks struggle to keep up with the changes in the regulatory environment, regulators struggle to manage their workload and effectively regulate their banks. The impact of these changes is that banks are receiving less hands-on assessment by the regulators, less time spent with each institution, and the potential for more problems slipping through the cracks, potentially resulting in an overall increase in bank failures across the United States.

The changing economic environment has a significant impact on banks and thrifts as they struggle to effectively manage their interest rate spread in the face of low rates on loans, rate competition for deposits and the general market changes, industry trends and economic fluctuations. It has been a challenge for banks to effectively set their growth strategies with the recent economic market. A rising interest rate environment may seem to help financial institutions, but the effect of the changes on consumers and businesses is not predictable and the challenge remains for banks to grow and effectively manage the spread to generate a return to their shareholders.

The management of the banks’ asset portfolios also remains a challenge in today’s economic environment. Loans are a bank’s primary asset category and when loan quality becomes suspect, the foundation of a bank is shaken to the core. While always an issue for banks, declining asset quality has become a big problem for financial institutions. There are several reasons for this, one of which is the lax attitude some banks have adopted because of the years of “good times.” The potential for this is exacerbated by the reduction in the regulatory oversight of banks and in some cases depth of management. Problems are more likely to go undetected, resulting in a significant impact on the bank when they are recognized. In addition, banks, like any business, struggle to cut costs and have consequently eliminated certain expenses, such as adequate employee training programs.

Banks also face a host of other challenges such as aging ownership groups. Across the country, many banks’ management teams and board of directors are aging. Banks also face ongoing pressure by shareholders, both public and private, to achieve earnings and growth projections. Regulators place added pressure on banks to manage the various categories of risk. Banking is also an extremely competitive industry. Competing in the financial services industry has become tougher with the entrance of such players as insurance agencies, credit unions, check cashing services, credit card companies, etc.

Farm Service Agency

FSA makes direct and guaranteed farm ownership (FO) and operating loans (OL) to family-size farmers and ranchers who cannot obtain commercial credit from a bank, Farm Credit System institution, or other lender. FSA loans can be used to purchase land, livestock, equipment, feed, seed, and supplies. Its loans can also be used to construct buildings or make farm improvements.

FSA loans are often provided to beginning farmers who cannot qualify for conventional loans because they have insufficient financial resources. FSA also helps established farmers who have suffered financial setbacks from natural disasters, or whose resources are too limited to maintain profitable farming operations.

Direct farm loans are made by FSA with Government funds. We also service these loans and provide our Direct loan customers with supervision and credit counseling so they have a better chance for success. Farm Ownership, Operating, Emergency and Youth loans are the main types of loans available under the Direct program. Direct loan funds are also set aside each year for loans to minority applicants and beginning farmers.

Direct Farm Operating Loans may be used to purchase items such as livestock, farm equipment, feed, seed, fuel, farm chemicals, insurance, and other operating expenses. Operating Loans can also be used to pay for minor improvements to buildings, costs associated with land and water development, family subsistence, and to refinance debts under certain conditions. Loan funds cannot be used to finance nonfarm enterprises, which include raising earthworms, exotic birds, tropical fish, dogs, or horses for non-farm purposes (racing, pleasure or show).The limit on Direct Farm Operating Loans is $200,000.

With a Direct Farm Ownership Loan, you can purchase farmland, construct or repair buildings and other fixtures, and promote soil and water conservation. The maximum amount for Direct Farm Ownership Loans is $200,000.Loan applicants may choose to participate in a joint financing plan. In this program, FSA lends up to 50 percent of the amount financed, and another lender provides the balance. FSA may charge an interest rate of not less than 4%.

USDA's Farm Service Agency (FSA) provides emergency loans to help producers recover from production and physical losses due to drought, flooding, other natural disasters, or quarantine. Emergency loan funds may be used to: 

• Restore or replace essential property;

• Pay all or part of production costs associated with the disaster year;

• Pay essential family living expenses;

• Reorganize the farming operation; and

• Refinance certain debts.

Farmer MAC

Federal Agricultural Mortgage Corporation, also known as Farmer Mac, is a stockholder-owned, publicly-traded company that was chartered by the United States federal government in 1988 to serve as a secondary market in agricultural loans such as mortgages for agricultural real estate and rural housing. The company purchases loans from agricultural lenders, and sells instruments backed by those loans. The company also works with the USDA.

C. Financial Regulation

An agricultural bank, according to the Federal Reserve Board, is a banking institution whose proportion of farm loans to total loans is greater than the un-weighted average at all banks (14.83 percent at the end of 2002).1 Ag banks serve a wide range of farms (see table). Borrowings for agricultural purposes generally fall into four broad categories: real estate, machinery and equipment, livestock, and crop production. Because loans in each category have unique purposes, terms, sources of repayment, and collateral, sound underwriting practices for ag loans are particularly important.

Without appropriate credit monitoring, sound underwriting practices are useless. Lenders must ensure that loan proceeds are used for the purpose indicated, and to do so, they may deliver the funds directly to the equipment dealer, livestock merchant, or input supplier. When the bank disburses funds directly to the borrower, it may collect receipts or perform inspections.

Because the decision to extend credit is based on the expectation that the borrower will generate sufficient income to repay the debt, lenders must monitor and analyze borrowers' financial statements and tax returns. Credit bureau reports should be reviewed periodically, as the accumulation of credit card debt and debt at unrelated institutions may have an adverse impact on borrowers' financial conditions.

Though cash flow from operations tends to be borrowers' primary source of repayment, the decision to extend credit is also based on the expectation that default can be recovered by liquidating the collateral. Therefore, lenders should inspect, value, and secure collateral during their evaluation and underwriting process. Once funds are disbursed, lenders should periodically inspect and value the collateral to ensure it is adequate to secure the loan. Banks should conduct periodic lien searches to determine whether the borrower has placed additional liens on the asset.

Of the four broad categories of agricultural loans, bankers and examiners need to pay special attention to revolving lines of credit that are used to finance crop production. Lenders should monitor advances on lines of credit and repayment sources. Because the payment schedule for lines of credit should match cash inflows, borrowers typically have a clean-up period during which the loan balance is paid in full. But when cash flow is insufficient and the line of credit cannot be retired during the clean-up period, the carryover debt should be segregated from new lines of credit, secured with additional collateral, and amortized over a reasonable term.

To mitigate their exposure, some ag lenders require borrowers to carry crop insurance, use hedging, or limit their lending to farmers who already have contacts for the goods they produce.

 

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