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Effects of Credit Crisis on Ag Industry Detailed in University Study

00:00AM Oct 20, 2008 Editors

How the current financial crisis affects agriculture and changes decision-making for producers is detailed in five new reports released by the University of Illinois Department of Agricultural and Consumer Economics.

The five-part package highlights the origin of the crisis, the effects farmers/lender relationships, implications on commodity prices, effects on crop insurance payments and volitility in farmland real estate.  

"The recent turmoil in financial markets is very large by any reasonable standard of comparison," says Scott Irwin, professor of agricultural and consumer economics. "The farmdoc team prepared these articles to illustrate the impact of the current financial crisis on the agricultural economy and decision-making.

"We've focused on five main topics – the nature of the financial crisis, impacts on the short-term availability of credit, the connection between the financial meltdown and commodity prices, crop insurance decisions, and land rental and lease negotiations."

How We Got There

"The simplest and most direct answer to how we got where we are today is that, over the past few years, too many 'bad' mortgage loans were made in the United States," says Nick Paulson, assistant professor of agricultural finance and author of "The Current Financial Crisis: How Did We Get Here?"

Paulson pointed to a combination of relatively low interest rates and credit availability which combined to create the boom in U.S. real estate markets. Borrower demand for home mortgages increased significantly and mortgage brokers, driven by profits determined by commissions, came up with creative ways to make loans available to a larger pool of potential borrowers.

"Additionally, the rapid increase in real-estate values provided justification for lending amounts in excess of market values without down payment requirements and/or documented proof of repayment ability," he says.

"Unfortunately, in 2006 the party literally started to end. Many of the existing non-traditional mortgage contracts become unaffordable to borrowers as variable interest rates adjusted upwards and balloon payments on no-interest loans became due."

The result--plummeting values for mortgage-based securities as default rates increase and investors shift money to safer investments.

"Investors are wary of putting their money at risk in debt markets, which makes it exceedingly difficult for lenders to obtain the financing needed to originate new loans or lines of credit, even to creditworthy borrowers--the money is simply not there to do so," Paulson says.

Financial Markets in Agriculture

Producers should not be surprised when their banker asks for financial information and cash flow projections before making a loan, say Paul Ellinger and Bruce Sherrick, two professors of agricultural economics and authors of the "Financial Markets in Agriculture" article.

The reaction by lenders is not likely a response indicating a loss in trust, but rather a requirement from the enhanced regulations of banks, according to Ellinger and Sherrick's research.

They conclude, however, that in general the financial health of agricultural lenders remains strong as they largely avoided the problems that beset the finance industry. Ag-lending is also an industry characterized by strong customer-borrower relationships.

"However, the economic downturn and declining interest rates have lowered profit margins in 2008 for agricultural lenders, and nonperforming and past-due loans have increased at most financial institutions," Ellinger and Sherrick write.

"The larger concern for agricultural lenders will be the impact of the current economic downturn on profit margins for producers," they write. "Rising input costs and cash rents, combined with lower commodity prices increase the operating fund needs and financial risks for producers and for lenders providing debt funds.

"Another concern involves the impact that shrinking margins will have on land prices and thus, on the financial health of their borrowers."

Implications for Prices

"Demand" is the key word in judging what the financial crisis may do to agricultural prices, say Irwin and Darrel Good, both professors of agricultural and consumer economics, in their article, "Implications of Credit Market Problems for Crop Prices."

"Slowing economic growth from the crisis and its fallout threatens the robust demand growth that agricultural commodities have enjoyed for the past two years in both the food and biofuels sections," they conclude. "Slowing economic growth would likely dampen the demand for livestock products, resulting in a weaker demand for feed."

And as the domestic and world economies slow down, demand for energy drops, particularly for crude oil. Lower crude oil prices, resulting in lower gasoline prices, result in lower ethanol prices--reducing the breakeven price for corn processed into ethanol.

Cash prices for corn and soybean crops are now well below expected levels. Irwin and Good feel that the price levels are below actual value based on likely livestock and energy prices.

"The apparent overreaction of crop prices to the downturn in financial markets suggests that at least a modest recovery in prices can be expected in the post-harvest period," they write. "The timing and magnitude of such a recovery will be heavily influenced by the confidence the market shows in a stabilization of the financial markets and the depth and duration of the domestic and global economic slowdown."

While retaining ownership of the crops is expensive, prospects for a price recovery suggests storing a substantial portion of the crop that has not yet been priced, particularly if on-farm storage is available, Irwin and Good indicated.

"Longer term, corn and soybean producers will have to make decisions relative to acreage allocation in 2009," they said. "Current projections of use and carryover stocks for the 2008-09 marketing year suggest that nationally there will be a need to shift three to four million acres from soybeans to corn."

Crop Insurance Payments

Authors Gary Schnitkey, U of I Extension farm financial management specialist, and Bruce Sherrick offer a detailed examination of various crop insurance types, scenarios, and products in "Increased Probabilities of Crop Insurance Payments."

Revenue products such as Crop Revenue Coverage (CRC) and Revenue Assurance (RA), and Group Risk Income Plant (GRIP) may make payments as a result of commodity price declines, they write.

"Insurance payments could aid in reducing some of the losses resulting from commodity prices declines," they conclude.

Volatile Rental Decisions

Amid U.S. and world uncertainty about economic performance, many farmers and landowners are in the midst of making farmland rental decisions for 2009, say Schnitkey and fellow U of I Extension specialist Dale Lattz in their article "2009 Rental Decisions Given Volatile Commodity Prices and Higher Input Costs."

"Price uncertainty has greatly complicated decision-making as it is difficult to accurately estimate farmland returns for 2009," they write. "This in turn leads to difficulties in setting appropriate cash rent levels.

"We suggest using share rent or variable cash rent arrangements. If a fixed cash rent arrangement must be used, we suggest waiting in setting the cash rent level. Cash rent agreements set at relatively high levels may need to be renegotiated."