Five Best Practices to Ensure It Is.
By Curt Covington
After a period of exceptional prosperity in agriculture, there are signs that the belt tightening in farm country has begun. Ag bankers responded positively to the demand from landowners by increasing lending for land purchases from $85 billion at year-end 2002 to $162 billion at the end of 2014. During this same period banks became major farm real estate lenders with farm real estate lending increasing from $38 billion in 2002 to $84 billion in 2014. Despite any potential challenges confronting banks when it comes to funding, securing, and servicing farm real estate loans, agricultural lending has become an important mainstay for many community banks and that is why ag lenders must be cognizant of the potential peaks and pitfalls that come along with farmland lending.
But how can community banks positions themselves to not only survive a possible correction in the farm economy but actually grow in less than ideal conditions? Most ag bankers around the country have memory of the 1980s to be prudent lenders when it comes to extending farm real estate loans and if they continue to adhere to these five fundamental “best practices”, they can continue to profit in a more challenging lending environment.
- Conduct thorough stress tests. Unexpected economic downturns and adverse market conditions can significantly harm a bank’s financial position. A well-managed bank always incorporates routine portfolio and commodity segment stress tests as part of a sound risk management strategy to identify its key vulnerabilities to market forces and assess how to effectively manage those risks should they emerge.
- Consider limitations. Having conducted thorough stress testing including a variety of scenarios, many community banks will set lending caps on real estate (e.g. maximum LTVs or maximum debt per acre), no matter how high farmland prices go. And even with volatility in commodity prices, using these practices, smart lenders will be well protected by farmland collateral.
- Invest in quality valuations. The anticipated tempering of the agriculture climate makes collateral valuation even more important. Not taking short cuts is paramount to ensure an accurate and reliable value of your investment.
- Shelter yourself from unnecessary risk. In such a prolonged low-interest rate environment, it can be tempting to reinstate the lending practices of the Savings and Loan industry of old – originate farm mortgages, fund them with deposits, and hold them in portfolio. Unfortunately, banks that operate under this model are restricted in the size and the kinds of real estate loans they safely offer. Farm real estate lending exposes them to increased credit and interest rate risk. Proper asset-liability management may cost more in the short-run, but taking the long-term view can pay dividends when interest rates begin to rise.
- Leverage the secondary market. In the darkest days of the farm crisis of the 1980s, a group of forward thinking ag lenders created a secondary market for farm real estate mortgages. Twenty-five years later, Farmer Mac continues to offer a mechanism for community bankers to increase their product offerings, improve their liquidity, and help manage any asset-liability mismatch. Another added benefit – on average, banks that have sold farm real estate loans into the secondary market have actually grown their ag portfolios at a faster pace than those who have not.
Farm real estate collateral can be an ag banker’s best friend when times get tough or a boat anchor for those who fail to adequately manage the risks inherent in ag real estate lending. But, if lenders remain pragmatic in their approach and properly manage farm real estate lending risk, they can position themselves to seize farm lending opportunities that others miss during volatile times.
Curt Covington is the Senior Vice President for Agricultural Finance at the Federal Agricultural Mortgage Corporation (Farmer Mac) the secondary market for farm real estate mortgages that was created by Congress in 1987 in response to the farm crisis. Farmer Mac provides risk management solutions to community banks that originate farm real estate mortgages.