The Credit Crisis and Agriculture: Too much happy talk?
Monday, 26 January 2009 Michigan Farm News January 15, 2009 By David B. Schweikhardt
The impact of the credit crisis on the state of Michigan is in the news daily. Much of this attention has focused on non-agricultural industries in Michigan, especially the automobile industry.
As the credit crisis has unfolded in recent months, virtually everyone in the agricultural sector - from the Secretary of Agriculture on down - has maintained that agriculture will not be affected by the crisis. In many cases, this "happy talk" can be summarized as follows: "Agriculture will be not affected by the credit crisis because we had record net farm income last year, there were record exports, the farm sector's balance sheet is strong, and the credit crisis involves irresponsible sub-prime borrowers, not farmers."
While this view - that the agriculture sector has such financial strength that it can withstand a financial crisis that is affecting every other sector of the economy - may prove to be true, it is time to recognize that the credit crisis could affect agriculture through several different economic channels.
The origins and evolution of the credit crisis
The origins and evolution of the credit crisis are too complex to be detailed in this article. The origins of the crisis are rooted in sub-prime mortgage lending that led to high rates of default on home mortgages, lax underwriting standards by many lenders that failed to confirm the repayment ability of borrowers, regulatory standards that permitted issuing loans that had a very low probability of repayment, and an increasing level of consumer and corporate debt. This mix continued to brew through the 1990s and during the past decade.
In the spring and summer months of 2007, several major mortgage lenders collapsed as the default rates on mortgages began to rise. In August 2007, investors became alarmed at the rising foreclosure rates and the fact that many of the mortgage-backed securities (bonds) they had purchased were declining in value as it became apparent that the bondholders would never be repaid. Because a number or large commercial and investment banks also owned mortgage-backed securities, the financial condition of these institutions also began to erode, further eroding investor confidence.
Though several events in 2007 and 2008 indicated that the situation was continuing to worsen and to spread on a worldwide scale (for example, Northern Rock Bank, a British bank, collapsed under the weight of its U.S. sub-prime losses in September 2007), the public continued to ignore the issue until September 2008. During the week of Sept. 14, 2008, Lehman Brothers investment bank collapsed, again under the weight of its sub-prime mortgage obligations.
In the two days that followed, a flight to quality ensued as investors, having lost confidence in many forms of corporate stocks and bonds, began to sell them and move their funds toward government bonds in the hopes of acquiring investments that would protect their principle, even if it meant earning an extremely low interest rate. As this flight to quality ensued, interest rates on government bonds declined and the spread between the interest rate on government bonds and on comparable corporate bonds widened. For example, the interest-rate spread on 3-month commercial paper (bonds sold to create credit loaned to business borrowers) versus 3-month U.S. Treasury bonds is normally in the range or 0.1 percent to 0.2 percent (commercial paper rates are 0.1 percent to 0.2 percent higher than the safer Treasury bonds). After the events of August 2007, that spread widened to 0.5 percent for much of the first half of 2008.
Following the events of September 2008, this spread widened to historically high levels. Immediately after the Lehman Brothers collapse, this spread reached over 2.0 percent, much higher than its normal rate. As another measure of credit market tightness, the LIBOR (London Inter-bank Overnight Rate) also reached record levels, indicating that banks were unwilling to lend to each other. At the time of this article, the rate on 3-month Treasury bonds, which had been in the range of 3.7 percent in August 2007, had fallen to 0.02 percent in December 2008. Similarly, the U.S. Treasury held an auction of 4-week securities that were sold at a 0.0 percent interest rate.
Though 3-month commercial paper rates declined somewhat since September 2008, the spread between 3-month commercial paper rates and 3-month Treasuries remains in the range of 1.5 percent. Such data suggest that the credit crisis is far from being over, despite recent actions of the Federal Reserve to reduce interest rates. More importantly, such data strongly suggest that the credit crisis has been transformed into a security crisis - investors are unwilling to lend to borrowers not because of interest rates, but because of a crisis of confidence. In the light of the sub-prime housing collapse, the collapse of investment banks and some commercial banks, reports of lax lending standards, and news of the $50 billion Madoff Ponzi scheme, investors are seeking the safest possible investments regardless of what interest rates are being offered by other borrowers.
As farmers face the 2009 growing season, they need to face one major fact - such a crisis in the financial system cannot be fixed with traditional tools of monetary and fiscal policy alone (i.e, reductions in interest rates). Only the passage of time - and solid institutional performance that will revive investor confidence - can address much of the damage that has been done. Consequently, the credit markets are very likely to be tight well beyond the winter and spring of 2009.
Agriculture's connections to the credit crisis
Much of agriculture's happy talk about the credit crisis has focused on the availability of credit in spring 2009. Though this is an important issue, the impact of the credit crisis on agriculture will continue to operate through several channels beyond the availability of loans in spring 2009. Each of these channels deserve to be considered during the coming year.
First, when considering the availability of credit for the 2009 crop year, farmers should expect lenders to demand more information on repayment ability. This is likely to require additional information on worst-case scenarios, collateral availability, and liquidity. Increased information standards and higher underwriting requirements are increasingly demanded from other commercial borrowers. There is no reason to believe that farmers can escape this trend because of last year's farm economy.
As noted earlier, farmers should be planning now on higher interest rates for the coming year. Again, non-farm borrowers are already facing such increased borrowing costs. Greater competition for all forms of credit will affect the interest rates paid by borrowers. It is unrealistic to expect that farmers will not face higher interest rates in such an environment. A strong balance sheet will not be enough to obtain short-term credit in the existing environment. The emphasis will also be on the liquidity of the borrower. Thus, borrowers' ability to repay loans from current earnings or cash reserves will likely play a much greater role in judging the creditworthiness of borrowers.
Second, if the credit crisis results in a worldwide recession, as is now expected, the impact on export demand is likely to be felt in commodity markets. For example, during 2005-2007, export demand remained strong, even in the face of higher commodity prices. At least some of this strength was explained by the increased demand for protein (meat) that is caused by rising income levels in countries such as China and India. But the reverse also applies - if income growth in those countries is reduced by a worldwide recession, those countries are likely to witness a decrease in the demand for protein, thereby limiting U.S. export demand and putting downward pressure on commodity prices.
Third, a worldwide recession is also likely to affect the price of oil. If income growth slows, demand growth for oil is likely to slow, reducing oil prices. Because corn prices are now tied to oil prices through the ethanol market, declines in oil prices are also likely to put downward pressure on corn and other commodity prices.
Fourth, the condition of commercial banks remains widely variable and is, in some cases, worsening. Large banks were involved in the issuance of sub-prime mortgages and exotic financial derivatives that have created major risks for those banks. Regional and local commercial banks, by and large, were not involved in such transactions and have more limited exposure to such risk. Regional and local banks, however, may be more exposed to construction loans and commercial real estate loans. Such loans are also experiencing an increased rate of default with the collapse of the housing market. As these problems erode the balance sheets of commercial banks, the lending capacity of commercial banks will be reduced. The FDIC "watch list" of banks facing financial difficulties reached 171 banks in the third quarter of 2008, doubling the number of banks on the list in 2007. It is widely expected that there will be a rising number of bank failures in 2009, thereby increasing the pressure on credit availability
Fifth, most analysts believe that housing prices must fall 30 percent from their peak level of 2007 to reach their historic relationships with income, population and construction costs that have prevailed since World War II. Since national housing prices have fallen 15 percent to 20 percent from their peak, it is likely they will fall an additional 10 percent to 15 percent by 2009. Such a development will expose additional financial institutions, even those with prime borrowers, to the sort of pressures now being witnessed in other parts of the credit markets. At the same time, it is possible that housing prices will overshoot this expected 30 percent decline, leading to a larger decline in housing prices before reaching a bottom. The worsening of a U.S. recession is especially likely to cause such overshooting to occur.
Sixth, credit provided by some input suppliers could be affected by the lack of credit available in the commercial paper market. Consequently, producers should be especially careful in assuming that such sources of credit will be available.
Seventh, the availability of export credit is also likely to affect U.S. agricultural exports in the coming year. Nearly all export transactions are carried out through export letters of credit that guarantee the exporter that he will receive payment when the traded goods arrive in the import country. As credit markets have come under pressure, the availability of export credit has also decreased in recent months. Such markets are also experiencing a crisis of confidence. Exporters are unlikely to ship goods to a buyer when that buyer's letter of credit is being provided by a bank of unknown quality in a foreign country. Thus, exporters are demanding greater evidence on the creditworthiness of import buyers and their financial institutions. A reduction in the availability of export credit, or an increase in its cost, would also be likely to put downward pressure on U.S. exports and commodity prices.
Conclusion
As a result of these trends, the impact of the credit crisis on U.S. agriculture could be greater than is commonly perceived at this time. Farm credit availability, buyer credit availability, and commodity prices could all be affected by the crisis. Two final points deserve mention. First, farmers should expect the effects of the crisis to be felt far beyond the spring of 2009. The effects of this issue could reverberate in credit markets for years, and the implications of this issue should be considered for both short-term and long-term planning. Second, the comments above only touch upon what could be a complex and rapidly changing economic environment in the next few years. Beyond these comments, issues of deflation, inflation, asset price valuation, acceptable debt burden, and financial flexibility all deserve consideration.
David B. Schweikhardt is Professor in the Department of Agricultural, Food, and Resource Economics at Michigan State University.
