Ag lenders preach the virtues of hedging to protect borrowers - and themselves - against bungee-jumping prices
Doug Tippens is no Hillary Clinton, but he is a believer in cattle futures.
As executive vice president of the tiny American Heritage Bank, Mr. Tippens says that using cattle futures and other agricultural derivatives helps his ag borrowers hedge against wild price fluctuations that make it tougher to repay loans.
The bottom line for the El Reno, Okla., banker: Cattle and grain farmers who use futures to lock in profitable prices are sounder credit risks.
"We really believe in it," said Mr. Tippens, who divides his time between farming and lending at the $45 million asset bank. "Using derivatives is a way to shift the [risk] of prices falling to somebody else."
Experts say that as few 10% of ag producers nationally use puts, forwards, and options to lock in proce protection.
However, usage is growing. Lenders like Mr. Tippens are pitching derivatives to ag borrowers as a form of insurance that costs as litle as $1 a head o6 livestock or pennies a bushel.
For instance, a rancher might purchase a put option that would establish a floor, or minimum price, at which his herd would be sold. At the same time, the rancher could purchase a call option, which would set a ceiling or maximum price, if he were purchasing cattle.
A third general type of derivative is a futures contract, which allows the rancher to agree to lock in the selling price for his cattle.
Because their customers are the derivatives, there is no direct risk to the bank. Many bankers say they will lend more - often ar lower rates - to farmers who use the products. None requires hedging because the potential lender liability if the strategy goes wrong.
How It Works
Steve Hatz, senior vice president and head of ag lending at Firstier Financial Corp., based in Omaha, said he might be comfortable increasing the loan amount to 75% of the value of a herd from just 70% - if a cattle farmers uses a put to lock in the price of his beef.
But he emphasized that the prospect of a bigger loan isn't the primary reason a farmer would use a hedge.
"The market drives their decision to buy a put," Mr. Hatz said. "They won't do it because we'll lend them more."
Mr. Tippens says a majority of his borrowers use derivatives, but his bank is the exception. Observers blame the spotty use of such tools on the reluctance by many farmers to try something new and on a lack of understanding by bankers and borrowers alike.
Says Farmers Isn't Enough
"Therehs a growing sense among agricultural lenders that for their customers to succeed they have to be good risk managers," said Mark Drabenstott, an economist at the Federal Reserve Bank of Kansas City. "In the past there was always a sense that if yoou drove past the field and your crop looked O.K., then everything was all right."
But the failure of farms and its toll on rural banks in the 1980s woke up many to the need to understand the costs and risks of doing business.
"The risk of farming is higher today then it has ever been in history," said Ronald Ence, director of ag finance at the Independent Bankers Association of America. "We've had the flood of the millennium in the Middlewest, drought in the South, and fires and earthquakes in California."
Because of that, he said, more of the nation's 4,000 ag lenders are increasingly looking for ways to manage the risk that cash market prices will change with the weather.
Almost the biggest obstacle to increasing use of forwards, puts, and options are the farmers themselves.
"I think there are a lot of misunderstandings about how these work," said Jerry Skees, an agricultural economist at the University of Kentucky. "A lot of these farmers or ranchers end up in a speculative position, rather than just hedging. That creates a bad taste for a famer if they get burnt."
Others say that usage by farmers is hard to measure because many enter a forward price contract with a local grain elevator, in which they agree to deliver crops at a set price on a specific date.
The elevator operator then hedges that contract by purchasing a put on option on the exchange.
The single biggest hurdle to using options is overcoming the increadible complexity of he commodities markets.
"It is so complicated that most people will just stay away from them," said Jan Ridgely, assistant vice president and ag lender at the Citizens National Bank, a $120 million asset institution in Albion, Ill. "Other people will keep doinga it until they lose money and then they quit."
Observers say that many ag lenders also need education.
"A lot og guys know just enough to be dangersou," said Mr. Tippens, the Oklahoma banker. "This is like any tool: You have to use it wisely. If you drive a tractor blindfolded, you can get hurt."
Education in Futures
In an effort to broaden the use of their hedging contracts, the Chicago Mercantile Exchange and the Chicago Board of Trade run how-to seminars nationally for lenders and farmers.
Patricia Pembroke, market development manager at the Board of Trade, where grain crop futures are traded, said that ag lenders increasinglu push borrowers to develop marketing plans designed to be more profitable.
As an example, she said the Illinois Farm Bureau found a decade ago that fully 80% of its members did not know their cost of production. But, Ms. Pembroke said, that situation is changing and risk management is part of the change.
The Chicago Merc's Clinton Hakes agrees. As farmers better understand costs, he said they have become more savvy at understanding how to lock in profitable prices by using an option, which sets a minimum price.
"By setting a floor on your price, the only risk is that you've paid for price insurance you don't need," Mr. Hakes said.
After all, volatility makes commodity futures valuable. While inclement weather is the farmer's enemy, it is a friend of traders in the pits which are betting which way bungee-jumping prices will go next.
American Heritage's Mr. Tippens worries that the years of relative stability in the cattle markets may be testing the willingness of his borrowers to use futures to lock in prices that have not fluctuated widely since the mid-1980s.
"What it's going to take is a cattle [market] crash to make people see the value of this," he said. "It's getting extremely difficult to convince them every year that it is worth the money and that scares me to death."