Magazine article The Journal of Lending & Credit Risk Management

New Policy Affects Commodity Risk in Agricultural Lending

Magazine article The Journal of Lending & Credit Risk Management

New Policy Affects Commodity Risk in Agricultural Lending

Article excerpt

Commodity risk resulting from market volatility driven by farm policy changes presents special challenges to lenders. The vulnerability of agricultural lenders to changes in farm policy depends on:

1. Impact of the policy change on the profitability of specific commodity production and the value of collateral supporting the loans.

2. Lender exposure (portfolio concentration) to affected commodities.

3. Initial credit quality of loans to producers of affected commodities.

Farm policy changes that reduce debt servicing capacity increase the likelihood that adversely classified assets will fail to perform and that non-criticized assets will encounter future performance difficulties. This concern presents potential adverse consequences to credit-dependent producers. According to a poll conducted during the 1995 North American Agricultural Lenders Conference, 35% of the lenders surveyed expected changes in government programs to decrease the availability of credit to customers. Their opinion is supported by the Federal Deposit Insurance Corporation's recent Report on Underwriting Practices, which concluded that changes in government support payments will present problems for 40% of agricultural lending institutions. Clearly, recognizing the implications of farm program changes and understanding how to assess their impact are critical to effective management of risk in agricultural lending.

Background

Since the 1930s, farm policy focused on controlling supplies of commodities in an attempt to increase market price and, ultimately, net farm income. In recent years, crop acreage base restrictions and annual acreage idling and conservation programs were used as supply controls. Contemporary farm policy debate focused on determining how to modify programs to achieve a desired level of federal budget outlays.

The last round of debate culminated in the Federal Agricultural Improvement and Reform (FAIR) Act of 1996. Considered by many to be the most historic farm legislation reform in decades, the FAIR Act accelerated the trend of reducing government involvement in, and financial support of, agricultural markets by eliminating crop bases and acreage reduction initiatives. The tradeoff for producers is "freedom to farm," as farmers now are allowed to make their own planting decisions, free of government regulation. They also are not required to set aside productive farm land in order to participate in the farm program.

FAIR Provisions

The FAIR Act abolished the link between what farmers plant and how much the government pays them. Target prices and deficiency payments for wheat, feed grains, cotton, and rice were eliminated. Producers of these commodities are able to contract for fixed, declining payments over the next seven years, regardless of market prices. This "safety net" transition period to a free market orientation will allow farmers and their lenders to change their business practices in preparation for the new environment, in which commodity prices will be driven by world supply-and-demand balances, thus becoming more volatile.

Other significant provisions of this market transition policy include continuance of the Conservation Reserve Program at a slightly reduced level and with enhanced controls intended to ensure enrollment and reenrollment of legitimately qualifying "highly erodible" cropland; and changes to the dairy program resulting in declining support prices and consolidation of federal milk marketing orders. …

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