Rain, Rain, Come Again

My oldest made the trip home this weekend from his job in north central South Dakota.  Along the way he noted that he was seeing fewer cattle than he normally observed along the way.  He also noted that some fields that a month ago were full of wheat are now being baled into hay.  It is a sign of the times.

The latest US Drought Monitor has all of North Dakota, almost all of South Dakota, and the eastern third of Montana in a drought as of June 20, 2017.  A big portion in east Montana is rated as extreme, as spots in the Dakotas are.  Most of the rest is in the moderate to severe drought area.  The drought is beginning to move wheat prices higher, as the crop yields and quality is expected to suffer. 

Drought is a win-lose situation, if you are in an area not impacted by the drought, you will have a higher price for your commodity.  If you are in the drought area, you don’t have the commodity to take advantage of the higher price.  The other problem with this drought now for the Dakotas is that it comes after we are a few years into this commodity super-cycle of lower prices.  The days of high wheat prices in 2012 and 13 are but a memory now.  So, farmers have been dealing with much lower gross and net revenue streams over the past several years.  Many of you are now dealing with maybe the second year of how to deal with carryover debt that has not been resolved yet.

This will have a negative impact on the lenders in the area as well.  Note that not only the producers of grain and cattle, but also small town businesses are also going to be negatively impacted.   Dr. Kohl of Virginia Tech, believes that these factors will cause up to 30% of operators to liquidate in the next few years.  I think in areas where the weather is not favorable, that number will be even higher. 

Now is the time, and for many of the lenders, you have already been assessing this, to identify additional risk you may be prone to and seek to exit relationships where you can.  Kohl outlined ten credit risks in a recent article and believes that if you have seven of them present and can exit the relationship, you should.  With the drought, that number may be lower.

1.        Trade volatility-movements in the commodities markets can easily cause an operator to sell for a lower than break-even price.  Your producers need to know where their break-even price is at and what protections they are undertaking to protect them from operational losses.

2.       Living expenses-we often come across lenders who want us to underwrite deals with lower living expense factors.  These rose rapidly during the good price times and take longer to come back down.  The ND Ag farm record reports the median family living costs at $72,000 annually.  If the farm operation is too small and the only source of income is from the farm, it is likely not profitable enough to cover family living expenses. 

a.       Here also watch off-farm sources of income.  Before the price peak, spouses would often have jobs off the farm to provide extra income and also cover insurance costs.  When the prices rose to the stratosphere, some quit their day job since the farm was able to take care of their family expenses and more.  Now that pattern has flipped.

3.       Non-farm capital expenses-watch out for the new toys, personal vehicles, high end vacation homes, boats, retirement houses in Florida.

4.       Cash flow margins and taxes-poor cash flow margins and poor tax planning may result in too much taxable income.  Also watch managing from tax records without factoring in accrual adjustments. 

5.       Debt concentration-if you have too many loans to small operators with too much debt or too many loans to operators in poor producing areas, these both cause problems.

6.       Collateral complacency-the lender who thinks they are so well secured that they can lend without covenants or proper controls may face losses that devalue their collateral position.  Always focus on cash flow and look at collateral value with suspicion. 

7.       Regulator overreaction-regulators have acted moderately so far.  They have provided warnings but have not brought down the hammer yet.  When that does change, there has been a tendency in the past to overreact and force the lender to push out too many loans quickly with will result in excessive legal costs and more losses.  Take time now to cull out the portfolio in a sound manner.  Also make a practice to not go into collection on a credit where you have not warned the borrower at some point in writing if they do not perform, that you will request to be paid off.

8.       Alpha pups and dogs-Alpha pups expand just for the sake of expanding without considering the need for profits and capital.  Alpha dogs expand wisely and strategically to cover these bases.  Are you dealing with a borrower who has either of these tendencies?

9.       Fraud-watch out for this as the time gets worse.  Grain checks do not show up at the lender’s door or farm critters may disappear.  Equipment may also be an issue.  Farmers may trade in your collateral for something else without telling you. 

10.   Next generation-changing the farm operations and ownership from one generation to another can be a challenge.  If the farm is too small to successfully produce sufficient net revenue for the family or if the young farmer is too leveraged, it will set up the farm to fail. 

Kohl said that if you have 7 or more of the above present, you need to exit the relationship.  This may be too lenient.  If you see 3-4 of these characteristics, it is time to begin planning to move the relationship or to at least begin using strong controls to manage the farmer.  The presence of any one of them warrants a discussion with the borrower. 

The last significant ag downturn we had lasted for 7 years.  We are sitting in year 3 or maybe 4 in the present challenging times.  I don’t see the issue of the low prices ending soon.  Couple this with some poor weather and you have a formula for disaster for marginal producers.  Only the ones large enough and who have enough price and operational expense controls will survive. 

When the producer is hurt, the next one hurt is the lender.  Now is the time for a more aggressive stance to managing your farm credits.