By Tim Amerson
AgFirst Farm Credit Bank
A lender is a highly specialized investor. Like any investor, the lender’s first priority is to not lose principal. The second priority is to generate a return commensurate with the risk involved in the transaction.
There are a number of ways a lender assesses the probability of being paid. A common method is the application of the 5 Cs of credit:
- The Capacity of the borrower to repay the loan,
- The adequacy of the borrower’s Capital reserves, which provides financial flexibility in the event that capacity is compromised,
- The value of Collateral pledged as security,
- Market Conditions that might have an impact on the borrower’s performance, and
- The borrower’s Character (does the borrower demonstrate integrity in honoring obligations?).
While the 5 Cs can be a useful framework for any type of lending, applying each “C” appropriately is a matter of truly understanding the borrower. That’s where working with a specialized lender is important to both the lender and the borrower.
Assessing a potential borrower’s capacity to service his or her debt is a relatively simple matter when the borrower’s cash flow consists of a weekly or monthly paycheck. That’s why you can find a lender on virtually every corner that will make consumer loans, such as car loans, boat loans, and credit card loans. In fact, you can go online and find countless lenders vying for such business, and your mailbox probably contains a few solicitations each week. You can even walk into an automobile dealership and walk out just a few minutes later with the keys to a shiny new car and a new car loan. Such lending is prevalent because it’s easy.
But what about lending to finance a crop that will be planted in the springtime and sold in the fall, assuming weather conditions are favorable during the growing season, and assuming it’s dry enough to harvest in the fall, and assuming that market prices for the crop hold up when it’s time to sell? What about lending to finance a tree farm, whose “crop” will not mature for many years, assuming it does not fall victim to fire, insects, or a housing slump that depresses the price of wood? What about lending to a poultry grower, who may grow out five flocks a year—or maybe four or three—depending on global demand?
Capital and Collateral
Of course, there’s always the safety net of the borrower’s capital reserves and the collateral pledged to secure the loan, but even these elements have some unique qualities that have to be considered. For example, it’s pretty easy to determine the value of an automobile or house, as market comparables abound. It’s also pretty easy to liquidate such assets most of the time. Of course there is some price volatility and/or depreciation involved in these items, but it is generally well understood.
But what if the borrower’s capital reserve is invested in a swine facility? What if the underlying collateral is a pork processing facility? What are they worth when hogs are selling for $0.70 per pound? What are they worth when hogs are selling for $0.40 per pound? What are they worth if the state they are located in just announced a moratorium on the building of new hog houses? What are they worth if a new producer just announced an expansion of its facilities? You see, determining the value of agricultural assets, and turning those assets into cash, can be a tricky business.
As you can see, a proper assessment of a borrower’s capacity to service debt and of the value of his or her capital reserves and collateral requires an intimate knowledge of industry dynamics and current conditions.
Consumer lending typically tackles the character issue by using credit reports. If the prospective borrower has a history of repaying his or her loans, then they are assumed to have a high probability of repaying future loans. That’s why you can get a credit card loan through the mail or online. That’s also why you can get an automobile loan through a car dealer. A good agricultural lender will get to know his or her borrower much more intimately. The lender will attempt to understand the borrower’s values and ambitions to make sure they are aligned with their business pursuits. For example, a spend-every-dime approach to life may be incompatible with a cyclical income stream that is often associated with agricultural production.
If you watch many old westerns, you’ll likely see more than one in which the evil banker connives to foreclose on some poor widow’s ranch. In the end, the cowboy in the white hat rides in, shoots some bad guys, and redeems the mortgage, and kisses the girl. While that makes for entertaining theater, that’s not real, modern banking. Capital and collateral remain important underpinnings of lending, but the lender’s goal is to not have to liquidate such assets. Rather, the lender’s goal is borrower success, as successful borrowers repay their loans as agreed (which generates a profit for the lender) and then borrows more. Put another way, the lender’s goal is to make good loans.
Much has been written lately regarding poor lending practices in the housing industry, which arguably led to the recent banking crisis and recession. Inexperienced and/or overly-aggressive lenders made loans to people who could not afford them (i.e. lacked capacity and capital). They also ignored market conditions that suggested over-building in some areas, thereby compromising collateral value. They also made loans to people of questionable character. In short, the lenders ignored the 5 Cs. This ultimately hurt both lender and borrower, as lenders suffered large losses and borrowers lost homes.
Similar situations occur when a particular segment is experiencing a period of prosperity. For example, low input costs and rising meat prices led to some expansion in the poultry industry several years ago. Inexperienced lenders, eager to take advantage of the “boom,” rushed into the market and made loans with liberal structures. Like the housing market, both lender and borrower were happy—for a while. Eventually (inevitably) the market turned sour, with input costs rising and meat prices falling. Borrowers that had been able to expand by taking out loans that required little equity and provided for low payments found themselves underwater, with no way out. One traditional agricultural lender reported that a number of borrowers that had gone to other lenders to get more liberal terms were now experiencing severe stress. One now-bankrupt grower lamented that he would still be in business had he listened to the traditional lender and not chased the then-attractive expansion financing.
Just as lenders tend to chase the “hot” market segments, they tend to limit financing for, or totally abandon, segments experiencing stress. As mentioned above, agricultural production can be a volatile business. Troughs in the inevitable cycles are exactly the time when lenders are needed. A good agricultural lender understands that economic cycles occur and structures credit facilities in anticipation of such downturns.
A borrower’s best friend is a knowledgeable lender. Such a lender will be able to share insights obtained from dealing with a number of similarly-situated borrowers. Also, such a lender will bring an element of objectivity that a borrower often needs. Remember, a good lender wants to get paid back and therefore will be working to ensure the borrower’s success. To get the most benefit from the lending relationship possible, agricultural borrowers should seek out a reputable, agricultural lending specialist.
It is also important to recognize that “agriculture” is not just a single business. Agriculture itself is a highly-diversified industry, encompassing the growing and processing of a vast array of crops and animals. A borrower should not just seek out an agricultural lending generalist, but one with expertise in the segment the borrower is involved in. For example, the best “hog man” in the business might not know beans (pardon the agricultural reference) about citrus production. Borrowers should therefore consider consulting with lending institutions that have expertise in their segment, or even better, a broad commitment to agriculture and depth of staff.
If you are looking for a high-quality agricultural lender with a longstanding commitment to agriculture, you might want to consider Farm Credit. The Farm Credit System was established by Congress in the early 1900s to ensure a stable, constructive supply of credit to agriculture. Farm Credit maintains a vast network of agricultural lending specialists, with offices located throughout the United States. Local lending staff have an in-depth understanding of the commodities commonly produced in their given area and will be well-acquainted with the farmers and ranchers that produce them. What’s more, each local Farm Credit lender can also tap the expertise of thousands of Farm Credit lenders located throughout the United States. This vast storehouse of knowledge can be invaluable to an agricultural producer.