Monday, April 28, 2008

A farm debt crisis? Part 3

This post continues the topic of the previous two posts. In this post, I discuss the Farm Credit System in the 1980s, and what is different today.

The 1980s were a time of crisis for the Farm Credit System. In response, Congress passed the Agricultural Credit Act of 1987. This Act provided for up to $4 billion of 15-year U.S. Treasury-guaranteed debt to bail out the System, of which $1.3 billion was eventually used. The last of this $1.3 billion was fully paid back in 2005.

The 1987 Act also required certain redistributions of capital within the System. Healthy institutions, such as those in the northeast, were required to make payments to support failing institutions. Two predecessor organizations of Yankee were required to make payments. (If you are curious about the details, see the first comment to this post.)

Could Yankee again be required to make capital contributions to support failing institutions elsewhere in the Farm Credit System? It is possible, but there are several reasons not to be overly concerned. In addition to a financial bailout, the Agricultural Credit Act of 1987 also made several other changes intended to prevent a similar crisis from recurring in the future.

First, the 1987 Act (along with other legislation in 1985 and 1986) greatly strengthened the Farm Credit Administration (FCA) as the regulator of the System. Previously FCA had been an advocate for the System. FCA became an arm's length regulator comparable to other banking regulators. FCA now has more powers, and more inclination, to prevent institutions from getting into trouble, and also more authority to act earlier and more decisively if they do.

Second, the 1987 Act established the Farm Credit System Insurance Fund to insure holders of Farm Credit System bonds against loss. System institutions pay into this Fund much as commercial banks pay into the Federal Deposit Insurance Corporation (FDIC) to insure small savers against loss. Currently the FCS Insurance Fund is $2.6 billion. This is 1.7% of outstanding bonds. While not huge, it is not small, either, and it did not exist at all in the 1980s.

Third, the System has a stronger balance sheet than in the 1980s, in terms of both capital and credit quality. (In this post "capital" means the same as members' equity or net worth.) The 1987 Act required FCA to establish capital standards for the first time, which FCA did in 1989—the 7% permanent capital standard. And System institutions have also adopted higher credit quality standards.

System accounting changed materially in 1985. Prior to 1985, the System's annual report to investors (aka the Annual Information Statement) was a consolidation of only the System banks and did not include the associations. Also, this report was not audited prior to 1985. The first independent audit in 1985 by Price Waterhouse (now PricewaterhouseCoopers) was a watershed event for the System. Many new accounting conventions were adopted in 1985. Accordingly, I will go back only to 1985 in my historical comparisons.

The risk funds ratio is one measure of capital. (The risk funds ratio is: capital plus the allowance for loan losses divided by assets plus the allowance for loan losses.) For the System as a whole, this ratio was 13.9% in 1985. It fell to a low of 10.7% in 1989, and nearly 1/3 of capital at that time was what was called "protected capital" which was more like a liability than capital. In 2007 the risk funds ratio was 14.5%, with no "protected capital." In addition, the portion of capital consisting of unallocated surplus, the most permanent form of capital, fell to a low of 26% in 1986 vs. 76% in 2007.

A good measure of credit quality is the ratio of high risk loans to total loans, referenced in the preceding post. This ratio, for the System as a whole, was 14% in 1985 and peaked at 23% (!!) in 1986. As noted in the previous post, we view 2% or less to be the standard for this ratio, and in 2007 this ratio was a very low 0.4% for the consolidated System.

In short, the System has more (and higher quality) capital now than in the 1980s and a much lower risk profile. Nevertheless, vigilance is warranted. Credit quality can deteriorate quickly, with little warning. And the trend in the risk funds ratio bears watching. It was as high as 17.7% as recently as 2004. But we are a long ways from the stress levels that the System experienced in the 1980s.