What effect has the subprime
mortgage crisis had on ag lending?

Larry Davis for Progressive Dairyman

Over the past 13 months, much has been documented about certain lending practices and subsequent repayment defaults on some residential home mortgages. The loans in question were most likely made to individuals with less than desirable credit histories, and/or income levels that were inadequate to meet repayment requirements. These subprime mortgages have caused significant losses to the banking and mortgage industry, estimated to be as much as $300 billion nationwide. Countless mortgage companies have gone out of business and several banks have failed.

The subprime mortgage losses incurred by the banking industry have been widespread and experienced by many banks that also loan money and provide various other banking services to individuals, organizations and businesses, including farms and agribusiness. The effects of these losses can be evaluated in two ways: the cost of capital and the credit standards by which new loans are granted. Let’s examine how both of these have changed.

Cost of capital
Because banks have taken significant losses on subprime loans, they have in many cases exceeded their own provisions for loan losses and have had to take additional write-offs and write-downs to their balance sheets as well as incurring losses to net income. These negative effects to the balance sheet and income statement have caused their stock prices to decrease giving them less available capital to lend. Due to this dynamic, the cost to a bank to acquire additional capital through borrowings has raised relative to U.S. treasuries and other published rates used as benchmarks for many consumer and business loans.

This rise in cost of capital has motivated many banks to offer higher returns on certificates of deposit, money market accounts and other types of deposits. In some cases, borrowers taking out new loans may see higher interest rates as a result of these changes. This higher cost, however, is difficult to ascertain because of the increased competition for good quality credits, which is discussed later in this article.

Credit standards
Significant changes have occurred in credit standards as a result of the subprime mortgage crisis. Specifically, these changes have been most dramatically realized in the consumer lending arena with regard to mortgage lending. Home equity loans, vehicle loans and credit cards have also seen credit standards raised making it more difficult for individuals with marginal credit (lower credit scores) to get these products. Individuals with good credit (higher credit scores) more than likely won’t see any difference in the availability of credit. In fact, individuals with good credit history may even see more options available to them because of the desire of banks to bring in good, low-risk customers.

Commercial lending standards have also been raised and tightened, although not to the same dramatic extent that consumer standards have changed. Commercial businesses (including farms and agribusiness) are being held to slightly stricter credit standards. Included in these changes are more frequent financial statement reporting and information requirements for larger borrowers. These changes could have resulted more from the dramatic increase in commodity prices than anything else. However, as with consumers, good quality commercial businesses probably enjoy more options because of banks’ interest in low-risk commercial customers.

Effects on ag lending
Banks will have a need to conserve capital and therefore will want to provide credit for the good to excellent consumer and commercial customers. Banks will also need a good return on that capital which will result in some higher borrowing costs to all borrowers. However, the overall availability of credit for the good to excellent credit customers should be adequate. There will be more emphasis upon providing a total banking relationship solution. The result down the road from these actions should be stronger lender and borrower relationships, which will benefit both parties.

Consumers and commercial businesses with marginal credit will have a tougher time finding credit and will pay higher rates because of their higher risk profiles. This is consistent with historical risk/reward models used by the banking industry. In the recent past, the market has not always rewarded the best risk (or penalized the marginal risk) in either consumer or commercial lending. That is now changing.

The subprime mortgage crisis will, without a doubt, change bank lending for several generations. Financial historians will write about the significant events that have taken place in the financial markets during the past year, in particular the government takeover of lending giants Freddie Mac and Fannie Mae that occurred in September. The year will also mark a time when the U.S. banking system was under the most stress since the Great Depression. We will undoubtedly see more reforms and changes to come. PD