Why regulators fear a land bubble
In the past month, I have received calls from the Washington, D.C., offices of two major financial institution regulators with concerns about a potential bubble in the farmland market. I know DTN has written several features on this topic, but I thought it would be worthwhile to look at the issue through the lens of a regulator.
In the 1980s, interest rates were high, the Farmers Home Administration (now Farm Service Agency, or FSA) was propping up the market, and the buyers of land were borrowing anywhere from 85 to 95 percent of the purchase price. Today’s buyers of farmland tend to be financially strong farmers and outside investors. A number of the deals are cash purchases and those that involve credit are a high percent equity. Unlike what happened in the residential real estate market, ag lenders haven’t been fueling the run up. However, real estate still makes up 87 percent of the total assets of the balance sheet of agriculture. Agricultural lenders are much more focused on repayment capacity such as changes in earned net worth (not just market value) and accrual adjusted net income (rather than just cash basis). But land is still the primary or secondary collateral for the more heavily leveraged borrowers.
One of the concerns about the estimated market value of land is that it is determined at the margin—the prices of land sold, i.e. comparable sales are a significant factor in determining current market appraised values. Therefore, as sale prices escalate, so do the market values on all land owners’ balance sheets.
Other than a few concentrated livestock operations, there have been minimal forced sales in agriculture for over 10 years. If farm income were to drop and debt servicing problems began to occur, forced sales would increase. If able buyers got nervous about reduced income prospects and believed land values could fall, many would start to sit on the sidelines. Then it would become a self-fulfilling prophecy that caused land values to fall as effective demand was reduced at the same time supply was increasing, causing the markets to overreact on the downside, just as it does on the upside when everyone jumps on the bandwagon. Alan Greenspan referred to this response as irrational exuberance/fear and said that 80 percent of market economics are psychology.
Regulators’ second concern relates to the potential for interest rates to increase dramatically as a result of the growing federal debt. A significant increase in interest rates could affect land values on two fronts. First, those borrowers who are more highly leveraged and whose repayment capacity margin isn’t strong would suffer a double hit if commodity markets return to more normal margins and interest expenses increased, particularly if they experienced much carryover debt.
The second issue is associated with the repricing of loans made for capital purchases over the last couple of years. In order to mitigate the risk associated with asset/liability pricing, many lenders have set up loans so that they will be repriced every three or five years, even if they are amortized over a longer period.
Because the yield curve is upward sloping, many borrowers have opted for shorter repricing rather than paying a premium to fix rates for the life of the loan. If borrowers are under stress and a significant portion of their debt suddenly saw a significant rate increase, their risk of default would be increased.
Again, this could lead to increased forced sales.
If I were a borrower with much potential for debt servicing problems in the event of a downturn in income or an increase in interest rates, I would seriously consider applying for an FSA loan guarantee. Borrower rights provisions enacted after the 1980s debt crisis remain in force. That means FSA still has the interestrate buydown provision if a reduced interest rate would allow a borrower to debt service in a period of financial stress. Both lenders and regulators can be more flexible about restructuring debt if it is backed by a federal guarantee.
Finally, lenders and regulators tend to rate loans based on the probability of default and the probability of loss given default. If land values were to fall, even financially strong and performing borrowers would likely see their interest rates go up as margins reflected higher risk ratings due to declines in their market value net worth and the need for lenders to build loan loss reserves.
None of this indicates we are sitting on the cusp of a bubble. I only want to point out why regulators are becoming increasingly concerned and wanting to be proactive at a time when there doesn’t appear to be major problems in the agricultural sector. — Danny Klinefelter, DTN