“The Farm Credit System: Reckless Lender to Rural America.”
That is the title of a 1990 report prepared for the American Bankers Association by Bert Ely and Vicki Vanderhoff, of Ely & Company, Inc., based in Alexandria, Virginia.
The Western Farm Credit Bank, is one of 11 farm credit banks and a larger number of producer credit associations nationwide that make up the Farm Credit System. The Ely report does not discuss the operations of any one member bank in detail. It does, however, provide insight into the lending practices that resulted in the Western Farm Credit Bank financing Francis Morgan’s highly leveraged purchase of the Hamakua Sugar Company.
According to the Ely report, the system’s major problems can be traced to 1971. That year, Congress allowed farm credit banks to base their loans not on the ability of a farmer’s land to generate income (that is, on the agricultural or income-producing value of farmland), but on the market value of the farmland. As Ely and Vanderhoff write, “Lending on the basis of the agricultural value of farm real estate essentially reflects the ability of the income produced by that land to service debt used to purchase that land.”
“Lending on the basis of market or collateral value, however, is another story, for this type of lending promotes speculative bubbles that inevitably burst,” they go on to say. As opposed to agricultural value, which can be fixed rather precisely on past performance, market value “can be tied only loosely to an actual sales transaction. This estimate usually is based on an appraisal that in turn may be based on other highly leveraged transactions that themselves are based on yet other estimates of what an asset might sell for. Thus, collateral lending based on appraisals can set off a vicious cycle. More lending drives up land values in the short term, which creates more borrowing capacity which when used leads to higher and higher leveraging of current cash flows.”
At the same time that it allowed the market value of collateral to be used as the basis for setting loan limits, Congress also increased the lending limit by 20 percentage points from 65 percent of the asset’s value to 85 percent.
Such valuations inflate the “speculative bubbles” described in the Ely report. At some point, the value of the land comes to be determined not so much by its income-producing potential, or even a more fanciful market-based appraisal, but simply by the size of the encumbrances it carries. That is, by so many people having assigned “X” value to a property, and by the owner of that property having obligated himself through debt to pay “X” for that land, all parties stand to gain by simply declaring the value of the land to be “X.”
By the time this occurs, the borrower is almost invariably indebted beyond any point where income from the property alone can bail him or her out. Income from the land, that is, is not sufficient to service the debt on the loan as well as to cover operating expenses. To pay the debt, one must resort to selling assets, as Francis Morgan is now attempting to do.
Volume 2, Number 11 May 1992