From Feast to Famine

To the typical agricultural banker, the next few years look bleak. Throughout wide swaths of the farm belt, prices for corn, soybeans, milk and other commodities have been drifting lower for years. And the burgeoning trade war instigated by the Trump administration in June only made things worse, as successive rounds of retaliatory tariffs enacted by our most important trading partners have since led to double-digit declines in already depressed commodity prices. It’s an untenable situation that can’t, and won’t, last forever. It’s also a sensitive subject, given the reluctance of most bankers to criticize President Donald Trump in today’s politically charged climate.

Whether the challenges in rural America end up hurting ag lenders through higher loan delinquencies and charge-offs is a function of how long commodity prices stay depressed. But if the current situation persists for an extended period of time, what is certain is that the burden will fall predominantly on smaller banks based in rural communities. In the first quarter of this year, the typical bank with less than $100 million in assets allocated 11.6 percent of its loan portfolio to farm loans, according to data from the Federal Deposit Insurance Corp. That concentration dropped to 4.4 percent at banks between $100 million and $1 billion in assets, 1.4 percent at banks between $1 billion and $10 billion in assets and to only 0.3 percent at banks with more than $10 billion in assets.

“I had the opportunity to chair the [American Banker Association’s] Agriculture and Rural Bankers Committee in Washington, D.C., so I know a lot of bankers across the country. And they’re all scared the same as I’m scared, because this isn’t turning around,” says Mike Firestine, a senior vice president at Fulton Financial Corp., a $20 billion asset financial holding company based in Lancaster, Pennsylvania. “Where do we as bankers draw the line? We don’t want our farmers eating up all their equity. But it’s a hard decision for them, because it’s not a matter of them owning a house and going to work every day. When they lose their farm, they lose everything.”

The troubles in agriculture today trace their roots back to better times. Starting in 2010, commodity prices began to shoot through the roof. Corn prices, which had largely traded in a band between $2 and $4 a bushel since the 1970s, climbed above $8 a bushel by 2012. The same was true for soybeans, which sold for an average of $6.40 a bushel for four decades until peaking at nearly $20 a bushel six years ago. A similar trend occurred in the milk industry, though prices for milk didn’t peak until 2014.

The spikes in commodity prices were largely driven by market forces-higher demand and lower supply. In the case of corn and soybeans, a combination of biodiesel and federal ethanol standards, and an ever-growing need for animal feed in China, ratcheted up demand. To meet the new fuel standards, for instance, corn production needed to increase by approximately 30 percent from 2010 levels, says Christopher Hurt, professor of agricultural economics at Purdue University. In the case of milk, meanwhile, droughts in places like Australia and New Zealand disrupted global supply. It was also around this same time that money began pouring into the futures markets for commodities from passive investors looking to diversify away from equities and fixed-income securities. The speculative behavior acted as an accelerant when it came to prices.

It was in this “golden era” for agriculture that the seeds were sowed for the dramatic decline in commodity prices experienced over the past year, as higher prices incentivized farmers to increase production. The domestic corn crop has exceeded 14 billion bushels in four out of the past five years, after typically coming in closer to 12 billion bushels. The impact on soybean production has been even more intense, growing by nearly 50 percent since 2012. This year, farmers in the United States planted more soybean acres than corn for the first time in 35 years. And in July, the U.S. Department of Agriculture (USDA) projected that excess stocks of soybeans for the current crop year will be a record 580 million bushels, roughly 50 percent higher than its previous estimate.

The same has been true in the milk industry. “When milk prices were good, what’d the dairy farmer do? Put in more cows. When milk prices were low, what’d the diary farmer do? Put in more cows. And that’s exactly what happened,” says Firestine. “We’re overproducing, and dairies have nowhere to go with their milk. At one point last summer, after the schools and colleges closed, there was so much excess skim milk that a local dairy required their producers to take one tank load every month and dump it in their manure lagoons.”

And it’s not only excess supply of commodities like corn, soybeans and milk that’s causing problems. “The high prices from a few years ago led farmers to get themselves into a bit of a corner,” says Grant Kosior, CEO of Global Ag Risk Solutions, a crop insurance company. “They bid the price of land up, and they upgraded equipment. This caused their fixed costs to increase. And the problem with fixed costs is that they’re fixed. High fixed costs are fine when commodity prices are high, but now that prices are low, these costs are weighing on working capital, which is the first thing bankers cut back on when they see farmers experiencing trouble.”

The net result is that farm income is struggling. In a survey by the Federal Reserve Bank of St. Louis, a majority of 24 agricultural banks within its district encompassing all or parts of seven Midwest and Mid-South states, reported a decline in farm income in the second quarter when compared with the same period a year ago. It was the 18th consecutive quarter in which that was the case. Furthermore, a majority of respondents to the survey said they expect farm income to continue declining next quarter.

The Federal Reserve Bank of Kansas City echoed these findings, highlighting a deterioration in both farm income and credit conditions throughout its district, which spans seven states across the Great Plains and Rocky Mountain regions. “On average, bankers across the district reported that nearly 30 percent of the dollar volume of their farm loan portfolios was experiencing at least minor repayment problems,” wrote Nathan Kauffman and Ty Kreitman, economists at the Kansas City Fed. Weaknesses were particularly significant in Nebraska and the Mountain States, noted Kauffman and Kreitman, where the portion of farm loan portfolios experiencing repayment problems exceeded 35 percent.

Importantly, these issues are still at an early stage, allowing bankers throughout major farming states to be measured in their response to the recent trend in commodity prices, if not outwardly upbeat given the record farm yields expected throughout certain parts of the country. “I would say we’re fairly optimistic,” said Kenneth Karels, CEO of Great Western Bancorp, a $12 billion asset bank based in Sioux Falls, South Dakota, that ranks as the sixth-largest farm lender in the country. Karels’ comment came on the bank’s second-quarter earnings call, where he continued by adding that: “We’re seeing some pretty good crops, probably some record crops in most of the area that we have.”

Yet, the two Fed surveys, as well as these observations, largely reflect the state of the agricultural industry prior to June-that is, before the Trump administration ignited a series of tit-for-tat retaliatory tariffs that sent commodity prices tumbling. The opening salvo was fired by the White House at the end of May, when U.S. Commerce Secretary Wilbur Ross announced import duties of 25 percent on steel and 10 percent on aluminum. This was followed in mid-June by $50 billion in tariffs targeting imports from China. Since then, China, Canada, Mexico, India and the European Union have each imposed reciprocal duties on a variety of U.S. goods and services, including a number of agricultural products.

Prices for domestically produced soybeans, which have been targeted by China’s retaliatory duties, dropped 17 percent in June alone. And from the beginning of May through mid-July, corn prices fell by an identical margin. “While the sharp declines in commodity prices may have had a limited effect on trends in farm income leading into the second quarter, the conditions likely had a greater influence on future prospects for farm income,” wrote Kauffman and Kreitman. “Income was expected to remain subdued across the district in coming months, but that effect could be exacerbated in states more heavily concentrated in commodities-such as soybeans-that have been targeted by retaliatory tariffs.”

There are two saving graces for banks in the short term. The first is that many farmers locked in prices for their corn and soybeans on the futures market prior to the floor falling out in June. This covers nearly half of Great Western’s farm customers, says executive vice president Doug Bass, who oversees Great Western’s operations in Arizona, Colorado, Iowa, Kansas and Missouri. “The other important piece is crop insurance,” says Bass in an interview with Bank Director magazine. “Our underwriting parameters are based on revenue insurance per acre. That’s one reason volatility-weather changes, commodity price changes-you concern yourself with them, but you don’t change your long-term trajectory.”

As a result, Great Western Chief Credit Officer Michael Gough noted on the bank’s second-quarter earnings call, “We continue to actively monitor the discussion around trade tariffs, with specific focus on soybeans and how that may impact our customers, but at this stage, we do not have significant concerns around potential impact on farmer profitability for the 2018 year.”

The longer commodity prices stay low, however, the worse things will get. Not only does an extended period of low prices impact farmers’ ability to hedge and insure their crops at profitable margins, but it also feeds on itself. “What a farmer does when commodity prices are low and his fixed costs are high is he starts to cut back on variable costs-fertilizer, seed and chemicals,” says Kosior. “So what ends up happening is that the only way a farmer can get out of trouble is to grow a big crop, which will get you through to the next year. But the only way to grow a big crop is to maximize on fertilizer, seed and chemical. And yet when working capital dries up because banks tighten the purse strings, the first thing to go is your fertilizer, seed and chemical. So the only pathway to getting free and clear is oftentimes already compromised before you put your crop in the ground.”

“I’ve seen prices this low before, but not for such an extended period of time,” says Firestine about milk. “What bailed us out before was that there was a major drought in other parts of the world. So there was less milk on the global market and it jacked up our prices. So, when I say there’s no light at the end of the tunnel, if there’s a major catastrophe in another country and their production goes way down, then it’s a plus for us. In this day and age everything is global. But right now there’s nothing on the horizon that would cause things to improve.”

With respect to international trade, moreover, the situation is only getting worse with each successive round of retaliatory tariffs. This has led to concern among farmers that once trading partners like China go elsewhere to avoid U.S.-imposed tariffs-to, say, buying a larger portion of soybeans from Brazil-those trading patterns will become permanent. This was the case during the commodity price bubble six years ago, says Bill Gordon, a soybean farmer in Worthington, Minnesota, and treasurer of the American Soybean Association. “That was when you had $7 to $8 [per bushel] corn and $20 [per bushel] soybeans,” says Gordon. “That killed our foreign markets. They started using other types of proteins in feed rations. We lost market share in the world by having those prices so high. And some of that hasn’t come back.”

Another potential consequence from an extended period of depressed commodity prices is further consolidation in the agricultural industry, says Firestine: “We’re taking a good hard look at the future of 100-cow dairies. In Pennsylvania, our main herd size is between 80 and 90 cows. Are we going to become what I like to call ‘chickenized,’ where in the poultry industry everything is larger farms on contracts? Are we going to have fewer producers and larger farms for the lowest possible cost and for a specific processor? Is that our future in the dairy industry? I hope it isn’t, but you have to be realistic about it.”

Fortunately, not all areas of the country have been impacted equally, with some regions doing better than others. Average crop yields throughout Mid-west states like Iowa, for instance, are expected to break records this year. Thanks to favorable weather, the USDA is projecting the average corn yield in the state to be 207 bushels an acre, six bushels above last year’s record yield. This will help offset lower prices. Additionally, the closer a farmer is to key transportation routes-the Mississippi River in particular-the more they get for their crops. “If corn is trading at $3.60 a bushel, farmers near the river market will get $3.60 to maybe $3.80 a bushel at their elevator,” says Gordon. “Whereas, out here, in Western Minnesota, I’m actually getting only $2.90 a bushel at the elevator because we have to ship it.”

Furthermore, while low prices for corn and soybeans are bad for farmers, they reduce the cost of livestock feed. As a result, ag banks serving heavy livestock-producing regions are likely to experience more muted effects from the decrease in commodity prices. “Farm income in our region is not as volatile as it is in row crop areas,” noted an Arkansas lender in the St. Louis Fed’s second-quarter Agricultural Finance Monitor. “We are mostly contract poultry and animal production. Independent cattle producers make up the balance of our agriculture production; those prices are off the highs but have stabilized.”

This has allowed larger, more diversified agricultural lenders such as Great Western to be less circumspect when it comes to the current state of agriculture-a luxury smaller banks don’t have. “Are we alarmed today? No. Are we cognizant of the impacts and understand what implications these lower prices may have? Absolutely. Are we changing what we do and how we do it? No,” says Bass. “If any lender in agriculture reacts to daily swings in the commodity market, you’re not taking a long-term view. Prices will be up. Prices will be down. We’ve lived through a lot of cycles. The important thing is to stick to your underwriting standards.”