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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. I [I, J I I I I I • • uo~6U!450m 04 0PI !!omOH 40~n 0!UJO~!I0) uo6~JO OUOZPl:l 0POI\~U 0>15011:) O)S!)UOJ:J UOS ~O~U08 aAJaSa~ IOJapa:J ~uaw~Jodaa lpJOasatJ 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