Handout #6
Agricultural Economics
489/689
Financial Intermediation and Ag
Lending Institutions
Spring Semester 2009
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A. Financial Intermediation
The savings/investment process in capitalist economies is organized around financial
intermediation, making them a central institution of economic growth. Financial
intermediaries are firms that borrow from consumer/savers and lend to companies that need
resources for investment.
There are numerous lenders providing loan funds to agriculture and related businesses.
Commercial banks are one of these lenders, and are a financial intermediary in the truest
sense of the word. They make loans using the deposits of lenders in addition to originating
loans and selling them in secondary markets.
Other lenders obtain loanable funds in other means. The Farm Credit System sells
consolidated system-wide bonds in the government securities market. Life insurance
companies use funds collected on policies (insurance premiums), the Farm Service Agency
uses funds appropriated by Congress, and lenders like John Deere Credit use funds
appropriated by the parent company.
B. Financial Institutions
Farm Credit System
The seeds of the Farm Credit System were planted by President Theodore Roosevelt in
1908, when he appointed a Country Life Commission to address the various problems
facing a predominantly rural population.
At the time, agricultural real estate loans from commercial banks, if they were
available at all, had prohibitively high rates and short terms. Until 1913, for instance,
federal law prohibited national banks from making loans with maturities beyond five years.
The commission's report documented a lack of any adequate agricultural credit, whereby a
farmer may readily secure loans on fair terms.
The report led to various presidential and congressional studies over the next several
years, which included extensive analysis of other nations' rural credit systems.
The credit delivery method established by the 1916 Federal Farm Loan Act was based
largely on Germany's Landschafts, which had operated since 1769 and appeared to be the
most successful of the various European cooperative ag-credit systems.
During the pivotal congressional debate over an American agricultural credit
system, nearly 100 different bills were introduced, which ultimately focused on three major
approaches:
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
Small, independent land banks, with federal charters but private capital. Proponents
of this concept favored the non-government funding, but critics feared its built-in
motive for high profits would not assure low rates to farmers.

Twelve federal land banks owned by their farmer-borrowers, partly capitalized by
the government and financed through the private purchase of tax-exempt bonds.
Advocates maintained this cooperative structure would guarantee low rates, but
critics disliked the government sponsorship and expense involved.

Direct government loans to farmers, favored by the nation's farm organizations but
opposed by most politicians.
Congressional proponents of these three approaches battled to a stalemate in 1914,
which led to the creation in 1915 of a Joint Committee on Rural Credits, which in turn
drafted the final compromise that was adopted in 1916.
Lawmakers chose a cooperative credit structure based on 12 Federal Land Banks
(FLBs), using $125 million in government seed money but financed by private capital from
investors.
One sidelight of the Farm Credit legislation is that it helped lawmakers prepare
themselves for more sweeping financial legislation. The chairman of the Joint Committee
on Rural Credits was Rep. Carter Glass of Virginia, who teamed up a few years later with a
colleague on the House Banking Committee, Rep. H.B. Steagall of Alabama, to write the
Glass-Steagall Act of 1933 the basic legal structure for most of the nation's commercial
banks.
The Early Years: Creation of the Farm Credit System coincided with World War I,
a very prosperous time for American farmers with the demand for food in Europe. But
prices collapsed after the war, and among the resulting economic problems were severe
shortages of short-term credit for farmers.
Congress responded with the Agricultural Credits Act of 1923, adding 12 Federal
Intermediate Credit Banks (FICBs) to the Farm Credit System. However, these were flawed
by procedural and geographic problems, and a long and complicated loan approval process.
Things went from bad to worse with the stock market crash of 1929, touching off the Great
Depression, throwing thousands of farmers into foreclosure and virtually shutting down the
System's ability to finance agriculture.
Three major agricultural laws followed that would lead to a sweeping reorganization
of the Farm Credit System:

The first was the Agricultural Marketing Act of 1929, enacted to help stabilize farm
prices and finance the development of agricultural cooperatives (which had been
authorized by the Capper-Volstead Act of 1922).
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
In 1933, Congress passed two crucial laws affecting the future of Farm Credit. One
was the Emergency Farm Mortgage Act, which recapitalized the land banks with
$189 million and cut interest rates to deal with the Depression.

The other was the Farm Credit Act, which, among other things, revamped the FICBs
and established a new production credit system for farmers and ranchers through
local Production Credit Associations. The Act also created 13 Banks for
Cooperatives.

President Franklin Roosevelt also issued an executive order in 1933 consolidating
the supervision of all the federal agricultural credit agencies under the new Farm
Credit Administration.

These various cooperatively owned financial entities, with the FCA as their
regulator, formed the basis of the Farm Credit System as it exists today.
Post-World War II Prosperity: During and after World War II, prosperity
returned to American farmers. The decade of the 1950s saw technology transform
agriculture, and also marked a major period of growth for the Farm Credit System.
Various laws were passed during this period which modified the directorship
arrangement of Farm Credit institutions as well as the structure of the FCA, and pushed the
System towards full ownership by its farmer/rancher-borrowers.
The System began a campaign in 1940 to pay off the government capital
investment, a goal the Land Banks achieved in 1947. The Banks for Cooperatives and the
last of the PCAs followed suit in 1968, leaving the Farm Credit System with all federal
capital repaid and completely owned by its borrowers.
With its government capital paid off, a National Services Commission on
Agricultural Credit was formed in 1969 to consider where the Farm Credit System should
head in the future. Its recommendations formed the basis for the Farm Credit Act of 1971,
the most sweeping update of the System's charter since 1933.
The 1971 act, along with amendments added in 1980, significantly expanded the
range of services Farm Credit institutions could offer, to include rural home mortgages,
leasing services, international and rural utility lending. It also expanded certain authorities
of local associations, and led to a major reorganization of the Farm Credit Administration.
Financial Stress in the 1980s: As agriculture plummeted into recession in the early
and mid 1980s, Farm Credit predictably suffered severe financial stress. During a three-year
period from 1985-1987, Congress passed several laws to deal with recessionary economic
and agricultural conditions.
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After this devastating period of rising inflation and collapsing farmland values, the
legislation of the mid-80s made several major revisions to the structure and operations of
the Farm Credit System and provided financial assistance in the form of a fully repayable,
privately financed line of credit which was guaranteed by the federal government. As a
result of the Congress' efforts:

Farm Credit Administration became a fully independent arm's-length regulator;

A limited and temporary government-guaranteed line of privately financed
assistance was provided to stressed System institutions;

Risk-based capital standards were mandated, to be determined by FCA;

The Farm Credit System Insurance Fund was created, financed by annual
contributions from System banks; and

The Federal Farm Credit Banks Funding Corp., which manages the sale of
Systemwide securities, was formally established by statute as a System entity;
In addition, a major consolidation of System institutions was undertaken. In the
early 1980s, the Farm Credit System was comprised of 37 banks and more than
1,000 local lending associations. Today, there are only 6 Farm Credit System banks
and a little more than 200 local lending associations.
As the 1980s drew to a close, and agricultural producers began their recovery from
the recession, Farm Credit began its return to financial health a trend that continued and
strengthened into the '90s.
Recent Years: In 1990-1991, Congress asked Farm Credit to play a greater role in
financing agricultural marketing and processing operations, as well as water and sewer
loans in rural communities.
In 1992, Farm Credit petitioned the Congress to enact legislation allowing Farm
Credit to repay in advance, the financial assistance provided in 1987. As a result, the
Congress enacted the FCS Safety and Soundness Act. The 1992 law clarifies the Farm
Credit System's obligation and makes provision for full repayment of all the assistance
borrowed, including interest. These developments ensure the System will have repaid all its
financial assistance, without any cost to the government.
That same year, all System banks met or exceeded the new 7 percent risk-weighted
permanent capital standard mandated by FCA -- an achievement that came nearly a year
ahead of schedule.
The System continued to show strong profits throughout the early 1990s. As a
result, the last of the four Farm Credit Banks that received financial assistance due to the
1980s recession redeemed its assistance -- almost 10 years before the 15-year assistance
bonds are due.
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The 1990s also have seen a continuation of trend toward consolidation in Farm
Credit, as the first Agricultural Credit Bank was formed by the merger of a Farm Credit
Bank and two Banks for Cooperatives. Consolidation is expected to continue.
The Farm Credit System (Farm Credit) is a nationwide network of borrower-owned
financial institutions and specialized service organizations. Farm Credit consists of five
Farm Credit Banks that provide funding and affiliated services to approximately 100 locally
owned Farm Credit associations and numerous cooperatives nationwide. The fundamental
purpose of this network of Government-sponsored enterprises created by Congress in 1916
is to provide American Agriculture with a source of sound, dependable credit at competitive
rates of interest. Farm Credit provides credit and related services to farmers, ranchers,
producers and harvesters of aquatic products, rural homeowners, certain farm-related
businesses, agricultural and aquatic cooperatives, rural utilities, and to certain foreign or
domestic entities in connection with international agricultural credit transactions.
Farm Credit provides some $103 billion in loans to more than a half million
growers, agribusiness and agricultural cooperatives, electric and telephone cooperatives,
and rural utility and water systems. Overall, more than 30 percent of the credit needs of
U.S. agriculture are met by Farm Credit institutions.
Today, Farm Credit institutions are organized as cooperative businesses, each
owned by it's member-borrow stockholders who have the right to participate in director
elections and vote on issues affecting the institution's operations.
Life Insurance Companies
One of the major life insurance companies providing loan funds to agriculture is Prudential
Life Insurance Company. Prudential Agricultural Investments, a specialized unit of
Prudential Mortgage Capital Co, supplies medium to long-term mortgage-based loans for a
wide range of agricultural properties. With an approximately $2.0 billion agricultural
mortgage portfolio, it has a rich history of experience in agriculture.
Prudential is proud of its heritage serving the mortgage needs of family farms,
ranches, agribusiness, and timberland owners for more than 100 years. It meets the unique
needs of individual landowners or large agribusiness firms in several ways. Backed by one
of the largest and financially solid institutions in the nation, it can:

Provide a variety of agricultural loan products and create mortgage solutions in
shapes and sizes designed to fit customer needs either directly or through its AgMap
network.

Cover a wide range of agricultural properties and land uses including annual crops,
permanent plantings, ranchland, timberland, and agribusiness facilities.
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
Stay abreast of issues facing the agricultural and forest product industries today, to
blend the lessons of the past with opportunities for the future.

Help customers create innovative financial solutions necessary to maintain future
viability of their agricultural enterprises.

Work closely with the professional staff in Prudential’s farm management and real
estate subsidiary.
Prudential offers competitive mortgage financing solutions for new acquisitions,
expansion and improvements, or re-financing existing debt for qualified borrowers seeking:

Fixed-rate, long-term (5-20 years) mortgage loans secured by agricultural land.

Adjustable-rate or variable-rate loan products from 1-5 years (amortized long term).

Flexible financing structures to meet your specific needs. Minimum loan size is
$500,000.

Total lending capacity up to $100 million per customer.
Prudential works with a wide range of agricultural property types to secure
agricultural loans:

Annual crops, including row crops, grains, cotton, and forage.

Permanent plantings, including orchards & vineyards.

Ranchland, including improved pasture and rangeland.

Timberland, including commercial forests in the Pacific Northwest or southeast.

Agribusiness facilities, including processing, packaging, & storage facilities.
Commercial Banks
The banking industry is a highly regulated industry with detailed and focused regulators.
All banks with FDIC-insured deposits have the FDIC as a regulator; however, for
examinations, the Federal Reserve is the primary federal regulator for Fed-member state
banks; the Office of the Comptroller of the Currency (“OCC”) is the primary federal
regulator for national banks; and the Office of Thrift Supervision, or OTS, is the primary
federal regulator for thrifts. State non-member banks are examined by the state agencies as
well as the FDIC. National banks have one primary regulator—the OCC.
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Each regulatory agency has their own set of rules and regulations to which banks
and thrifts must adhere.
The Federal Financial Institutions Examination Council (FFIEC) was established in
1979 as a formal interagency body empowered to prescribe uniform principles, standards,
and report forms for the federal examination of financial institutions. Although the FFIEC
has resulted in a greater degree of regulatory consistency between the agencies, the rules
and regulations are constantly changing.
In addition to changing regulations, changes in the industry have led to
consolidations within the Federal Reserve, FDIC, OTS and OCC. Offices have been closed,
supervisory regions have been merged, staff levels have been reduced and budgets have
been cut. The remaining regulators face an increased burden with increased workload and
more banks per regulator. While banks struggle to keep up with the changes in the
regulatory environment, regulators struggle to manage their workload and effectively
regulate their banks. The impact of these changes is that banks are receiving less hands-on
assessment by the regulators, less time spent with each institution, and the potential for
more problems slipping through the cracks, potentially resulting in an overall increase in
bank failures across the United States.
The changing economic environment has a significant impact on banks and thrifts as
they struggle to effectively manage their interest rate spread in the face of low rates on
loans, rate competition for deposits and the general market changes, industry trends and
economic fluctuations. It has been a challenge for banks to effectively set their growth
strategies with the recent economic market. A rising interest rate environment may seem to
help financial institutions, but the effect of the changes on consumers and businesses is not
predictable and the challenge remains for banks to grow and effectively manage the spread
to generate a return to their shareholders.
The management of the banks’ asset portfolios also remains a challenge in today’s
economic environment. Loans are a bank’s primary asset category and when loan quality
becomes suspect, the foundation of a bank is shaken to the core. While always an issue for
banks, declining asset quality has become a big problem for financial institutions. There are
several reasons for this, one of which is the lax attitude some banks have adopted because
of the years of “good times.” The potential for this is exacerbated by the reduction in the
regulatory oversight of banks and in some cases depth of management. Problems are more
likely to go undetected, resulting in a significant impact on the bank when they are
recognized. In addition, banks, like any business, struggle to cut costs and have
consequently eliminated certain expenses, such as adequate employee training programs.
Banks also face a host of other challenges such as aging ownership groups. Across
the country, many banks’ management teams and board of directors are aging. Banks also
face ongoing pressure by shareholders, both public and private, to achieve earnings and
growth projections. Regulators place added pressure on banks to manage the various
categories of risk. Banking is also an extremely competitive industry. Competing in the
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financial services industry has become tougher with the entrance of such players as
insurance agencies, credit unions, check cashing services, credit card companies, etc.
Farm Service Agency
FSA makes direct and guaranteed farm ownership (FO) and operating loans (OL) to familysize farmers and ranchers who cannot obtain commercial credit from a bank, Farm Credit
System institution, or other lender. FSA loans can be used to purchase land, livestock,
equipment, feed, seed, and supplies. Its loans can also be used to construct buildings or
make farm improvements.
FSA loans are often provided to beginning farmers who cannot qualify for
conventional loans because they have insufficient financial resources. FSA also helps
established farmers who have suffered financial setbacks from natural disasters, or whose
resources are too limited to maintain profitable farming operations.
Direct farm loans are made by FSA with Government funds. We also service these
loans and provide our Direct loan customers with supervision and credit counseling so they
have a better chance for success. Farm Ownership, Operating, Emergency and Youth loans
are the main types of loans available under the Direct program. Direct loan funds are also
set aside each year for loans to minority applicants and beginning farmers.
Direct Farm Operating Loans may be used to purchase items such as livestock,
farm equipment, feed, seed, fuel, farm chemicals, insurance, and other operating expenses.
Operating Loans can also be used to pay for minor improvements to buildings, costs
associated with land and water development, family subsistence, and to refinance debts
under certain conditions. Loan funds cannot be used to finance nonfarm enterprises, which
include raising earthworms, exotic birds, tropical fish, dogs, or horses for non-farm
purposes (racing, pleasure or show).The limit on Direct Farm Operating Loans is $200,000.
With a Direct Farm Ownership Loan, you can purchase farmland, construct or
repair buildings and other fixtures, and promote soil and water conservation. The
maximum amount for Direct Farm Ownership Loans is $200,000.Loan applicants may
choose to participate in a joint financing plan. In this program, FSA lends up to 50 percent
of the amount financed, and another lender provides the balance. FSA may charge an
interest rate of not less than 4%.
USDA's Farm Service Agency (FSA) provides emergency loans to help producers recover
from production and physical losses due to drought, flooding, other natural disasters, or
quarantine. Emergency loan funds may be used to:

Restore or replace essential property;

Pay all or part of production costs associated with the disaster year;
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
Pay essential family living expenses;

Reorganize the farming operation; and

Refinance certain debts.
Farmer MAC
Federal Agricultural Mortgage Corporation, also known as Farmer Mac, is a stockholderowned, publicly-traded company that was chartered by the United States federal
government in 1988 to serve as a secondary market in agricultural loans such as mortgages
for agricultural real estate and rural housing. The company purchases loans from
agricultural lenders, and sells instruments backed by those loans. The company also works
with the USDA.
C. Financial Regulation
An agricultural bank, according to the Federal Reserve Board, is a banking institution
whose proportion of farm loans to total loans is greater than the un-weighted average at all
banks (14.83 percent at the end of 2002).1 Ag banks serve a wide range of farms (see table).
Borrowings for agricultural purposes generally fall into four broad categories: real estate,
machinery and equipment, livestock, and crop production. Because loans in each category
have unique purposes, terms, sources of repayment, and collateral, sound underwriting
practices for ag loans are particularly important.
Without appropriate credit monitoring, sound underwriting practices are useless.
Lenders must ensure that loan proceeds are used for the purpose indicated, and to do so,
they may deliver the funds directly to the equipment dealer, livestock merchant, or input
supplier. When the bank disburses funds directly to the borrower, it may collect receipts or
perform inspections.
Because the decision to extend credit is based on the expectation that the borrower
will generate sufficient income to repay the debt, lenders must monitor and analyze
borrowers' financial statements and tax returns. Credit bureau reports should be reviewed
periodically, as the accumulation of credit card debt and debt at unrelated institutions may
have an adverse impact on borrowers' financial conditions.
Though cash flow from operations tends to be borrowers' primary source of
repayment, the decision to extend credit is also based on the expectation that default can be
recovered by liquidating the collateral. Therefore, lenders should inspect, value, and secure
collateral during their evaluation and underwriting process. Once funds are disbursed,
lenders should periodically inspect and value the collateral to ensure it is adequate to secure
the loan. Banks should conduct periodic lien searches to determine whether the borrower
has placed additional liens on the asset.
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Of the four broad categories of agricultural loans, bankers and examiners need to
pay special attention to revolving lines of credit that are used to finance crop production.
Lenders should monitor advances on lines of credit and repayment sources. Because the
payment schedule for lines of credit should match cash inflows, borrowers typically have a
clean-up period during which the loan balance is paid in full. But when cash flow is
insufficient and the line of credit cannot be retired during the clean-up period, the carryover
debt should be segregated from new lines of credit, secured with additional collateral, and
amortized over a reasonable term.
To mitigate their exposure, some ag lenders require borrowers to carry crop insurance, use
hedging, or limit their lending to farmers who already have contacts for the goods they
produce.