Lenders need to share in producers’ risk
June 22, 2015
During the past decade, South Dakota ag producers have had generally good prices, good moisture, and good yields. Though it rarely happens, there were even a few recent years where a producer's multi-peril insurance guarantee was higher than their cost of production, nearly guaranteeing a profit to the farmer. Because of the strong cash flow and virtually guaranteed profit, this made it fairly easy for lenders to approve new term loans and operating lines for their producers with very minimal risk to the producer or lending institution.
Fast forward to 2015. This "guarantee" is no longer the case and there is certainly risk in farming again. Producers in the Mitchell area are looking at $500 – $600 per acre to put corn in the ground, but the insurance guarantee is closer to $400 per acre, creating nearly $200 of shortfall to cover direct expenses. When you consider overhead expenses and family living, this could be closer to $300 – $400 of unguaranteed cash flow per acre. This would certainly be classified as risk and needs to be shared by both the producer and the lender.
Lending money to ag producers is often a risky endeavor, but can also be very lucrative to the lender as the loan amounts have grown exponentially in recent years. Despite low interest rates and lower margins during this period, lenders still enjoyed minimal risk in getting paid back. By definition, part of the bank's job is to take on risk. When they lend money to a producer they charge interest. This interest amount consists of the bank's cost of funds, a profit margin, and a risk premium. The riskier the loan, the higher the rate. This built in risk premium is essentially put away by the lender to cover their potential future losses from loans not getting repaid. I recall many times when I was a lender that a producer would have a profitable year and they would ask for a reduction in rate during their annual loan renewal. I enjoyed responding by saying "absolutely…as long as I can raise it next time you have a bad year!" They typically did not like that part!
Recently, lenders have been quick to tell the producers how they need to change their behavior and adjust to new economic conditions, but what about the lenders? Though they got comfortable during the good times, the lender needs to remember that they need to be willing to accept some of the risk, along with their producers. As a producer, you need to make sure you are working with a lender who truly understands ag and understands your operation.
Your lender is a very important part of your business, so you need to be transparent with them and make certain that they understand every aspect of your business. This includes capital purchases, loans with other lenders, marketing practices, family living expenses, and many others. Both sides need to work together to minimize and manage risk. The instructors at The South Dakota Center for Farm/Ranch Management work very well with producers and lenders, often serving as a link between the two so both sides are getting timely and accurate financial information to make decisions. If you would like some help with this part of your operation, please feel free to contact us at 995-7196 or firstname.lastname@example.org.