Ag Lenders: Cultivate Growth with Effective Pricing, Structure

The coronavirus pandemic has created turbulent conditions in ag lending in 2020, so understanding credit risk in current ag loan portfolios and effective pricing will be keys to solid returns for ag lenders in 2021.

Ag lending conditions improved in the third quarter as loan repayment rates and farm income stabilized with help from government programs and rising commodity prices. However, despite rising sentiment among farmers and some ag lenders, the highly uncertain outlook for the U.S. economy and agriculture finance warrants caution in agricultural lending activities.

“There’s still going to be good strong customers out there that have solid collateral to back their loans,” said Abrigo Senior Advisor Rob Newberry. “Lenders will need to identify their ‘good’ customers from their ‘bad’ customers and not chase loan opportunities they shouldn’t just because they have excess liquidity to lend.”

Lenders can make good loans for farm production and ag real estate despite the uncertainty related to the coronavirus pandemic, Newberry said. His top advice? “Make sure you understand the cash flow and make sure you are pricing for the risk you’re taking.”

Employing technology built for ag lenders can make assessing and monitoring creditworthiness of farm producers easier and more efficient. Ag loan pricing technology can also make decisions more subjective, ensuring that institution objectives are met while meeting borrower needs where possible.

How farmers have fared in 2020

The impact of the coronavirus pandemic on farmers in 2020 has been multifaceted, Newberry said. Among family farms (which make up 98% of all 2 million U.S. farms), nearly half of principal operators and spouses rely on a job off the farm to supplement low or negative farm income. But with numerous off-the-farm businesses closed due to COVID-19-related shutdowns, farmers and their family members lost important secondary sources of income for repaying loans. In 2021, Newberry said, a major question will be whether off-the-farm wages continue to support farm debt service coverage.

In addition, farmers have faced major disruptions to their distribution channels, and with rising COVID-19 numbers in many parts of the U.S., it’s unclear whether those disruptions will be repeated in the months ahead.

“When folks get sick at the meatpacking plant, they have to shut it down, and that backs everything up,” Newberry said. Earlier this year, beef and pork processing plants couldn’t process as many animals as planned due to employee illnesses and related plant closings, so farmers had nowhere to sell their cattle and pigs. That created an oversupply at a time consumers were also struggling to get out to stores safely, which hurt demand. With just-in-time processing at play, the whole supply chain for meat producers got backed up.

Newberry noted that many producers got creative after the pandemic began, finding new ways to sell directly to consumers. New distribution channels and other learnings from 2020 should help in the event of future potential supply-chain disruptions.

Recently improved ag outlook

While still lower than a year earlier, farm income in the third quarter improved from the second quarter, according to the latest Federal Reserve District Ag Credit Survey.

The December U.S. Department of Agriculture (USDA) forecast for 2020 projects net farm income to increase by $36 billion (43%) to $119.6 billion, the third year in a row of increases. A late summer and fall rally in corn and soybean prices, along with a second round of payments to farmers tied to the Coronavirus Food Assistance Program (CFAP 2), contributed to the improved ag financial picture and to a more optimistic outlook among farmers. Direct government farm payments are forecast to more than double in 2020 from 2019, thanks to COVID-19- and trade-related assistance.

Indeed, 25% of respondents in the Purdue University-CME Group Ag Economy Barometer survey in October said their farm was better off financially now than at the same time last year. That’s the most positive response since the survey began in 2015 and up 11 points from September. Will the optimism last?

“A lot of farm income this year was based on government income, but once those programs run out, income will decline,” Newberry said. Some of the big questions for the 2021 ag lending outlook will be what government assistance is provided and whether distribution channels are operational.

Ag lenders impacted in 2020

Lenders saw higher farm loan delinquency rates in the first quarter, and ag lending activity slowed in the second quarter, in part, due to farmers receiving loans through the Paycheck Protection Program and other government assistance.

And even though both income and credit conditions remained weak in the third quarter, loan repayment rates improved from the second quarter, and farmland values “generally remained strong across all regions,” according to the Federal Reserve District Ag Credit Survey.

Farm sector debt in 2020 is projected to rise 4% to $435.2 billion, including a 6% increase in ag real estate debt, according to the December USDA farm sector income forecast. Farm assets, about 82% of which are real estate, are forecast to increase 1.5% to $3.12 trillion.

Lenders recently surveyed by the American Bankers Association and Farmer Mac were understandably focused on producer challenges and the impact on ag credit in 2021.

“[A]g lenders remain primarily concerned with the same three factors as last year: credit quality and the deterioration of agricultural loans (72.1% ranked it among their top 2 concerns), competition from other lenders (37.3%), and weak loan demand (25.5%),” according to the Fall 2020 Agricultural Lender Survey report, which is based on lender responses between Aug. 3 and Sept. 6.

About one of every five ag borrowers had requested a loan modification due to the pandemic and resulting economic downturn, survey respondents said. Nearly 22% of lenders reported an increase in ag production loan delinquencies, and 14% reported higher ag real estate delinquencies in the last six months. However, almost half or more of respondents expect delinquencies of each type of loan to increase over the next year.

Charge-offs for both types of loans stayed the same this year, according to most lenders surveyed, and respondents had a similar outlook for charge-offs to stay flat in 2021.

About half of those surveyed expect farms to shrink operations in the coming year. At the same time, 60% and 51% expect increased demand for ag production loans and ag loans secured by farmland, respectively.

Pricing, structure of ag loans critical

Given the uncertainty and recent trends, ag lenders will want to monitor loan portfolios carefully and work with borrowers, Newberry said. “You don’t want to throw good money after bad money,” he said. “At the same time, you don’t want to unintentionally create actual losses before you have to. And some of these borrowers struggling have been historically strong customers that should be able to recover given enough time.”

Given the low interest rate environment, ag lenders’ natural reaction might be to offer shorter terms on loans, Newberry said. And financial institutions might feel additional pressure to offer shorter terms as they compete on rates only against the lender down the street – or online. But that could be overlooking an opportunity to not only potentially reduce the financial institution’s credit risk but also to potentially maximize net interest margin and better meet the needs of your ag customer, he said.

Financial institutions that remember how loan pricing, credit risk, and asset/liability management all interact can offer more creative loan structures – both for refinancings and new loans.

“It’s really about that debt service,” Newberry said. “Can they make their debt payments? If not, can you offer them a longer-term product that allows them more of an ability to make that payment but also gives you more runway to make the deal work without extending additional credit?”

“If you leverage the low interest rate cycle, you can refinance some ag loans you already have to help with lower payments for a certain time to help them through that period -- if they have lost income from off-the farm wages, for example,” Newberry said.

A financial institution could, for example, restructure a current five-year variable-rate loan into a 15-year or 20-year fixed-rate loan, which would help the borrower in the short term with lower payments and the long term with a lower interest rate. Meanwhile, the lender could buy a long-term hedge against the interest rate risk by buying protection through the Federal Home Loan Banks. “That’s why asset/liability management becomes so important in this low interest-rate environment, especially as financial institutions are trying to refinance deals and figure this out,” he said.

Ag lenders must also look for opportunities in loan pricing to price in higher risk if it is present – either in the interest rate, origination fees, through offering a niche product or service, or in some other way. “Your financial institution may agree to offer a lower rate on the operating line if the customer will bring their real estate loan to your institution,” Newberry said.

“If the competitor’s pricing a loan down the street and based on your cost structure you can’t match their offer, it’s OK to say no and don’t do that loan,” he said. “But sometimes financial institutions are so risk-averse about interest rate risk they don’t see the opportunity to change some of the dynamics to take some of the business away from competitors. If you don’t take any risk, you’re not going to make any money. Then you’re stuck with a really low return.”

By Mary Ellen Biery, Abrigo