How much credit do you really need?

It’s a question lenders are asking growers after a year of strong growth in agricultural lending and relatively strong crop prices that have delivered healthy returns to growers. Distinct from the squeeze on credit that’s hit other sectors of the economy, the limits growers face will force them to make the most of their profits and pay closer attention to cash flows.

"Our agricultural business and agricultural clients have never really had better economic times, so really our credit quality as it relates to agribusiness sector is really quite good," said Tom Robbert, senior vice-president with Key Bank in Yakima, Washington. However, a commitment of credit to one client has to be backed by an institution’s assets; the more credit a bank extends to one client, the less there will be for other clients.

"If they’re operating on more of their own money, we’re probably going to approach them and say, ‘How much do you really need for this year?’ and if there’s a reduction, then we’re probably going to try to make those adjustments just to free up capital for other clients," he explained.

Prudent lending

Key Bank is one of the top five agricultural lenders nationwide, with $1 billion in agricultural loans outstanding. Vegetable and fruit producers are its largest groups of clients in the Pacific Northwest.

The shift to a more conservative stance reflects the general rise of prudent lending practices in the wake of the subprime mortgage crisis, which was largely precipitated by mortgages that were packaged up and sold to institutional investors, who might then resell them. The lenders making the loans didn’t have to worry about them, so long as the risk of default was being borne by someone else. And until 18 months ago, there was almost always someone else.

That’s not the case today.

Reducing the amount of credit extended lowers the risk lenders face if a borrower defaults on the loan, and Robbert believes it’s in borrowers’ best interests to have less debt to play with as the current economic cycle for agricultural commodities passes its peak.

"We’re undoubtedly going into a downturn from the peak, so we just want to be prepared to have clients ready for the cycle as it changes," he said. "We want to offer the right amount of commitment level to support a client’s needs, and so it’s not to just arbitrarily reduce but to ensure there isn’t an excess out there."

The growth in farm debt is visible at Northwest Farm Credit Services in Spokane, a cooperative with implicit federal backing that currently operates with a 12 percent capitalization. Its $9-billon lending portfolio increased 20 percent in 2008, more than double expectations.

Farm Credit is still able to offer credit to existing customers and accept new business, but NWFCS Executive Vice-President Fred DePell said tighter lending practices at banks and the withdrawal of some insurance companies from the mortgage market have sent growers looking elsewhere for credit.

"There is pressure, there is no doubt about it," he said.

Strong land values and input costs have only intensified the need, DePell said.

Capital expansion

The growth in lending activity in recent years has been driven by stronger crop prices that have spurred capital expansion and land acquisition. Dramatic increases in the cost of fertilizer and other inputs have compounded the financial pressure on growers.

"If you want to go out and look at the development costs to put an irrigation system and a high-density trellis system on an undeveloped site, we’ve had situations where some of those costs have increased 20 percent to 25 percent compared to what they were just a year ago," DePell said. "Those have been huge drivers within the tree fruit industry."

While returns for apple, pears, and cherries were healthy this year, DePell harbors a concern that a decrease in prices could impact growers’ ability to pay back the debt they’ve taken on.

"This is a really good time for producers to maintain their liquidity and to look at making sure that they’re basing any capital purchase decisions, any longer term decisions, on traditional commodity prices, so that as this thing cycles through they don’t get their heads ripped off," he said.

Cash flow planning isn’t necessarily growers’ strong point, however.

Steve Jannicelli, a business financial advisor with Moss Adams LLP in Santa Rosa, California, discussed the issues wineries and vineyard owners face in the current business climate at a seminar Moss Adams co-hosted with the Washington Wine Industry Foundation in December.

Cash flow forecasting is something grape producers tend to do "seldomly and poorly," he said.

But it’s an essential tool in the current environment, especially where access to outside sources of capital is limited, and interest rates stand to increase modestly.

"Going outside of the business to borrow money should always be close to a last resort," he said. "You would certainly want to see the business funded by its own operations, by cash flow generated internally."

As the comments by DePell and Jannicelli indicate, the discussion around farm business loans is increasingly focusing on the recessionary pressures rather than the credit worthiness of farm businesses. And the economic recession that’s currently under way could ease in the second half of 2009, if the analysis of CIBC World Markets senior economist Benjamin Tal holds true.

Tal believes the focus on the recession rather than the crisis in credit indicates that the troubles are working through the system, and will be followed by gains in consumer confidence. This promises to boost the U.S. economy, heralding an economic renewal.