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FRBSF

WEEKLY LETTER

December 20, 1985

Farm Credit System
Severe financial stress in sectors of the economy
often is accompanied by calls for protective
government intervention. We have heard those
calls in the cases of Chrysler Corporation and Continentallllinois Bank. More recently, attention has
focused on the Farm Credit System, which is reeling from depressed conditions in agriculture.
Representatives from the Farm Credit Administration have proposed a number of "self-help"
measures as well as legislative changes calling for
greater centralization of decisionmaking in the
Farm (::redit System and more flexibility in the
system's ability to redistribute its capital. The
measure that has generated considerable debate
within the Congress and the Administration is the
request for a line of credit with the Treasury for the
Farm Credit Administration. In this Letter, we provide some background on the Farm Credit System
and its financial problems, and discuss the implications of Treasury aid.

A brief sketch
The Farm Credit System (FCS) is an elaborate
cooperative, borrower-owned network of farm
lending banks under the supervision, examination
and coordination of the Farm Credit Administration
(FCA), an independent federal agency. Administratively, the FCS is composed of 12 regional farm
credit districts. As of September 1985, FCS loans
outstanding totalled $70.7 billion.
The 12 Federal land Banks (one in,each district)
account for most of the loans in the system, or
about 68 percent. These land Banks make longterm mortgage loans through the more than 400 '
Federal land Bank Associations. Twelve Federal
Intermediary Credit Banks account for about 22
percent of the system's loans and comprise the
main source of funds for the Production Credit Associations (PCAs). Some 370 PCAs make primarily
short-term production loans to their members.
Thirteen Banks for Cooperatives (there is one
central bank for cooperatives) are important
sources of funds for agricultural and aquatic
cooperatives. The loans extended by the Farm
Credit System generally have floating rates. Most
loan rates are adjusted only with the approval of
the FCA and a few loans are linked by contract to
market rates.

Since 1979, the FCS has funded its loans and other
assets primarily through the issuance of systemwide consolidated obligations. Priorto that date,
individual components of the Farm Credit System
raised funds independently. The liabilities of the
Farm Credit System consist mainly of 6- and 9month securities and intermediate term coupon
instruments (mostly securities with maturities in
the range of 2 to 5 years). The system also issues
short-term discount notes on a more or less continuous basis (currently about $10 billion outstcmding).

Dimensions of the problem
The financial fate of the Farm Credit System is tied
in large part to the health of its members - the
farmers. In the 1970s, prospects for farmers, as
reflected in the sharp rise of farm land values, were
quite good. In the early 1980s, inflation expectations dropped sharply and brought down the rapid
appreciation of real estate in generaL At the-same
time, the farmers were hit by the effects of a strong
dollar and a high volume of agricultural production
worldwide. The FCS (as well as other agricultural
lenders) found itself facing borrowers with heavy
debt obligations, weakening incomes, and declining land values - the latter representing collateral
for much of its loans.
With the deterioration in farm incomes and land
prices, outstanding FCS loans have contracted by
about $7 billion from the peak level reached in
1982-83. The contraction in loans by the FCS,
however, has done little to protect the system
from a deterioration in the quality of its assets. At
the 37 FCS banks, loans reported as not accruing
interest rose from $2.0 billion in June 1985 to $3.5
billion in September, but even this higher figure
understates the problem. Representatives of the
FCS have indicated that over the next couple of
years, assets in the system not accruing interest
(real estate and loans) could rise to $13 billion.
The total value of "problem assets" of the Farm
Credit System, of course, is not at risk because
many loans are collateralized to some extent.
Nevertheless, Farm Credit System losses are
expected to rise sharply in the near future. By its
own estimate, the Farm Credit System expects to
lose as much as $3 billion over the 1985-87 period.

FRBSF
Critical to the FCS' capacity to handle these problems is the strength of its capital position. As of
September 1985, the book value of the capital,
surplus and reserves of the 37 banks in the FCS was
about $9.6 billion. On the surface at least, given
the projected losses in capital position, the FCS
would appear able to handle the current scope of
its problems. These problems, however, involve
more than the capacity of the FCS' current level of
capital to absorb losses.
Complications
The problems of the Farm Credit System are complicated by the uneven distribution of financial
strains in agriculture. "Non performing loans" as a
percent of total loans vary considerably among the
units of the Farm Credit System. Even in June of this
year, before market concern over the financial condition of the FCS intensified; the percentage was
quite high at some individual units, particularly the
Spokane and Omaha intermediate credit banks,
both of which have required special assistance.

Because of the uneven distribution of problems,
the Farm Credit System has had to take steps to
redistribute net worth internally. The problems at
the Spokane bank were handled through the
purchase of bad loans by the newly formed Farm
Credit Capital Corporation. Other banks in the FCS
helped the Omaha bank by buying bad loans and
sharing their capital.
However, there has been some reluctance among
the stronger units in the Farm Credit System to
redistribute capital. As a result, the FCA has asked
the Congress for more centralized authority to set
the criteria under which the Farm Credit Capital
Corporation can make assessments on individual
units or require system institutions to purchase
Capital Corporation stock.
Another source of concern for the Farm Credit
System is the withdrawal of capital by its members.
The FCS is a cooperative system in which capital is
obtained from the members; farmers borrowing
from the system simultaneously subscribe to
capital. For example, a borrower of $100,000
typically must also purchase between $5,000 and
$10,000 in capital.
However, as the quality of the FCS loan portfolio
.has deteriorated, there has been a flight of some
good borrowers. They have paid off their loans and

left the system in order to recover the value of
their invested capital. Members of the FCS have
the incentive to do this since capital contributions
can be withdrawn at par value. In extreme cases,
some FCS banks are attempting to prohibit the
withdrawal of capital when a member pays off
loans, but such action has not been undertaken on
a systemwide basis.
The problem of adverse selection of borrowers in
the Farm Credit System is further exacerbated by
the system's approach to pricing loans. The FCS
generally prices loans by employing the average
cost of the system's liabilities. As a consequence,
when market rates were rising sharply in the 1970s,
the Farm Credit System was making loans available
at rates considerably below market rates sinc~
much of the outstanding debt had been issued at
lower rates.
More recently, average cost pricing has tended to
hold up FCS rates as market rates have fallen from
peak levels. Moreover, when pricing loans, units in
the FCS must take into account the need for
reserves, expenses and capital requirements,
which, in the current environment, also. would add
to loan rates. For example, the large volume of
nonperforming loans must be carried by higher
overall interest rates on FCS loans.
Cost of funds
Interest rates on loans from the FCS also are
affected by what the system's financial problems
have done to its cost of funds. Historically,
securities of the FCS as well as other agencies have
traded with yields slightly above those on comparable Treasury securities. In part, the relatively
low cost of funds for the federally sponsored agencies has been related to special factors such as the
exemption of interest income from state and local
taxes, as well as the financial soundness of the
agencies. But, the narrow spread between yields
on FCS and Treasury securities has been viewed
mainly as an indication of the market's belief that
the agency's securities are implicitly guaranteed by
the fe<;ieral government.

Over the past several months, the market's concern over the quality of the FCS loan portfolio has
offset at least some of the funding advantages
afforded the FCS as a sponsored agency. The chart
shows the spread in yields on FCS debt maturing in
6 months over those for comparable Treasury

I
Interest Rate Spreads on FCS Securities*
Basis Points

105
90
75

60
45
30
15
OL~~-l.._::::L_..l-_.l..-----J'------L._......J

MAR

APR

MAY

JUN

JUL
1985

AUG

SEP

OCT

NOV

• Estimated spreads on Farm Credit System (FCS) s,:curities
over Treasury securities maturing in six months. EstImates
are based on data for the last five business days of each
month.

securities. As the chart indicates, yields on FCS
debt ballooned in September. The figures reflect
data for the last week of the month, but concern in
the market was apparent in secondary market trading earlier in September. The higher spreads on FCS
debt persisted through late November.
Treasury assistance
In part because of the market's reaction to its problems, the FCA asked the Congress for assistance in
the form of a line of credit with the Treasury. In
early December, the full Senate and the House
Agriculture Committee voted to authorize the
Treasury to lend to the FCS as a backstop source of
liquidity. (The Senate and House versions ofthe bill
also provide for greater regulatory powers for ~he
FCA and centralization of the process for pooling
FCS resources to help troubled units in the system.)
The financial assistance that the Congress would
give the FCS does stop short of formally guaranteeing the system's securities. However, formal backing of FCS debt may not be required to reassure
the market, at least as far as FCS security holders
are concerned. We note that, to the extent Treasury lending to the FCS facilitates the repayment of
private holders of the system's debt, the assistance
plan would provide some protection for the
system's current security holders.
Perhaps even more relevant, it is not clear that the
market's reaction up to this point has been due primarily to worries that the FCS would be allowed to
default on its debt. The "risk premia" on the FCS
debt may reflect the concerns about liquidity risk

should short-term cash flow problems delay disbursements more than default risk per se. (Such a
situation is similar to that observed in 1984 during
the Continental Illinois crisis when, even with the
FDIC's guarantee of all of the bank's deposits, the
market demanded substantial interest rate premia
on large CDs issued by Continental compared with
those of other money center banks.)
From the point of view of the FCS, the reassurance
of its bondholders would be beneficial since it
could reduce the system's interest costs. A!so, the
willingness of the Treasury to provide funds to the
FCS could .allow for a more orderly disposal of
assets by the system that could, in turn, dampen
the FCS' losses.
Nevertheless, Treasury lending is by no means a
cure-all for the. FCS. The measures as they stand do
not address the system's fundamental problem the quality of its loans and the potential for sizeable permanent losses from bad loans. Financial aid
will not turn bad loans into good loans. If Treasury
aid is limited strictly to the provision of liquidity,
members (capital holders) of the Farm Credit
System still are at risk.
Summary
The depressed condition in the farm sector. has .
taken its toll on farm lenders. The problem IS particularly acute for the FCS since it specializes in lending to support agriculture. The FCS ~o~ only mus~
face the problem of managing an eXisting portfolio
of problem loans, but also the threat that better
quality borrowers will leave the system and
thereby reduce its level of capital.
The Congress has acted on requests for a greater.
centralization of decision making in the Farm Credit
System, including giving the system mo.re au:hority
to redistribute its net worth as well as finanCial
assistance in the form of a line of credit with the
Treasury. The potential for backstop lendi~? by the
Treasury is intended to reassure FCS secuntles
holders. Such reassurance would benefit the
system, in part, by reducing its co:t of fu.nds. Even
with such aid, the FCS expects to Incur sizeable
losses because of the rising volume of nonperforming loans.
Frederick Furlong and Randall Pozdena,
Senior Economists

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco or of the Board of Governors of the Federal Reserve System.
br .
Editorial~omments may be addressed to the editor (Gregory Tong) orto the author •.•. Free c~pies ofFederal Reserve pu Ica~lons
can be obtained from the Public Information Department, Federal Reserve Bank of San FranCISco, P.O. Box 7702, San FranCISco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments' 2
Loans and Leases' 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts -Total
Time Deposits in Amounts-of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks

Excess Reserves (+ )/Deficiency (- )
Borrowings
Net free reserves (+ )/Net borrowed(-)

Amount
Outstanding

11/27/85

Change from 11/28/84
Dollar
Percent?

Change
from

11/20/85

198,473
179,804
51,803
65,669
38,044
5,427
11,342 _
7,327
203,961
51,824
33,081
14,338
137,799
45,737
38,465
26,117

1,255
952
554
29
240
11
215
88
3,160
3,060
368
86
14

-

-

-

11,680
11,612
774
4,125
7,036
376
300
369
14,839
9,007
4,689
2,134
3,697

67

-

Period ended

2,119
4,213

5.2
- 19.2

Period ended

11/18/85

14.2

11/4/85
25
17
8

1 Includes loss reserves, unearned income, excludes interbank loans
2

-

5,703

125
1,620

40
19
21

-

6.2
6.9
1.4
6.7
22.6
7.4
2.5
5.3
7.8
21.0
16.5
17.4
2.7

Excludes trading account securities

3 Excludes U.s. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers

S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annual ized percent change