Before it failed in April, New Frontier Bank in Greeley, Colo., was one of the nation's largest lenders to dairy farmers. So a month after it went bust, the Congressional Oversight Panel, the watchdog for the Troubled Asset Relief Program, held a hearing in the bank's hometown to find out if the failure was an isolated event or if it signaled broader problems in the agricultural economy that might require a TARP-like rescue of farmers and ranchers.

After hearing rival bankers label many of New Frontier's borrowers as "unbankable," the panel concluded that New Frontier fell victim to its own mismanagement. Still, the overseers heard enough from farmers and bankers to confirm their belief that the robust farm economy was weakening and, in late July, issued a report warning of a rough road ahead.

"The agricultural sector has fared somewhat better than the broader economy," said COP chairwoman Elizabeth Warren in a conference call. "Recent trends and projections in farm lending, however, are quite troubling. ...The economy crashed earlier, and now the ag sector is showing some real down arrows."

The U.S. Department of Agriculture projects that net-farm income for 2009 will decline 20 percent over last year, to $71.2 billion. Blame falling commodity prices. Dairy farmers are losing money on every gallon of milk they produce. Cattle and hog farmers are breaking even, at best. Meanwhile, exuberance over ethanol has tempered, and export demand is down.

The effect on agricultural banks is that delinquencies and chargeoffs are up, while returns on equity and assets are declining.

The good news is that conditions aren't bad enough to warrant a bailout. Farm loans continue to outperform other types of loans and most ag banks remain profitable. "We're waving the yellow flag," Warren said. "It's not all the way to a red flag."

At commercial banks, through the first quarter of the year, the share of total farm real estate loans delinquent reached 2.76 percent, up from 1.66 percent through the same period last year, according to the COP. Seasonally adjusted delinquencies for agricultural production loans rose from 1.06 percent in the first quarter of 2008 to 1.71 percent for the same period this year.

Chargeoffs inched up, too, though they are still miniscule. Farm real estate chargeoffs rose to 0.051 percent in the first quarter, from 0.008 percent the same period last year. Net chargeoffs for non-real estate farm loans went from 0.02 percent in the first quarter of 2008 to 0.11 percent this year.

The concern among farmers and bankers is that, without a broader economic rebound, demand will continue to weaken, prices will continue to fall, and delinquencies will spike. Already, there are signs that banks are getting skittish about extending credit: According to the COP, demand for direct operating loans from the Farm Service Agency, "the lender of last resort," was up 81 percent through the first eight months of fiscal year 2009, over the same period in FY 2008, and demand for direct ownership loans from the FSA has increased 132 percent over the same period.

"Every day you tune in to the commodity markets and they're lower," says Keith Carlson, the president of United Farm & Ranch Management, which manages more than 400 farms in Nebraska and is a subsidiary of $3.3-billion-asset TierOne Bank in Lincoln. "If we have these lower prices for a year, we're going to have farmers who are forced to sell what they produced for less than what it costs to produce. If they don't sell, a banker is going to make them sell it."

Still, bankers say that the farm economy is going through a downturn, not a crisis, and their big concern is that regulators might overreact. Income, though down from a year ago, is still higher than the 10-year average, interest rates are near historic lows, and farmers' debt-to-income levels are manageable, industry experts say.

"A lot of the investments that were made, in terms of land purchases or equipment purchases, were done with a higher level of cash and limited their debt leverage, which should help the overall financial health of the industry," says Jason Henderson, vice president and Omaha branch executive at the Federal Reserve Bank of Kansas City

Already, though, bankers say their ag loans are coming under greater scrutiny.

"In a few cases we've heard that examiners want to treat ag real estate loans as if they were commercial real estate loans, which raises concerns from bankers because the examiners are being very strict on commercial real estate loans," says Mark Scanlan, the vice president of agricultural and rural policy at the Independent Community Bankers of America.

One Midwestern bank CEO, who asked not to be named, said that during a recent review, the examiner pressed harder into the bank's farm loan portfolio because of what happened with New Frontier.

Regulators even seem to be bracing for more failures of ag-focused banks. John Blanchfield, senior vice president of the American Bankers Association's Center for Agriculture and Rural Banking, says that the Federal Deposit Insurance Corp. is in talks with the ABA to train examiners on farm loan workouts, though details were still being hammered out as this magazine went to press.

Roger Sturdevant, executive vice president and head of ag banking at Bank of the West in San Francisco, says that underwriting standards at New Frontier were not representative of the industry as a whole.

Sturdevant contends that New Frontier would offer a $1,500 loan for a dairy cow with a market value of $2,000. Bank of the West, and most other banks, Sturdevant says, would offer something in the neighborhood of $1,000 for the same cow.

"They were extremely aggressive," he says. "They were lending $400 or $500 an animal higher than what we would, and what I would suggest the industry norm is."

From a government regulation standpoint, the industry has already seemingly dodged one bullet. The COP decided that forcing a farm loan restructuring mandate for TARP recipient banks was not "the right lever" to pull, says the COP's Warren, since only about 10 percent of all real estate debt resides with TARP banks. Industry groups pushed hard against this proposal.

Also on the table, should the sector continue to decline, Congress could devote a portion of the remaining TARP funding to a farm mortgage foreclosure mitigation program that would extend beyond TARP recipients. Or, Congress could use TARP money to create a loan guarantee program for restructured farm loans. Finally, Congress could simply step in and bail out the most troubled ag industries.

No sector of the ag economy is more troubled than dairy. Milk prices are down 41 percent through June 2009 compared to June 2008. The cost of production has shot up due to feed and energy costs rising, so the cost of production, about $20 per hundredweight, is roughly double what dairy producers are receiving. Supply is so outpacing demand that the Cooperatives Working Together program has begun buying up herds of cows to slaughter them for meat production.

According to Wells Fargo's Kenneth McCorkle, executive vice president of agricultural industries, and economist Michael Swanson, the reason why dairy prices have fallen so precipitously is because of decreased demand. There was a contraction in global gross domestic product that depressed demand in once-key export growth regions, they say, and the European Union lifting its suspension of export subsidies created further pressure on exports.

"The big question, the unanswered question," says Blanchfield, "is what happens to the global economy in the next 12 months, because so much of what we produce on farms in this country depends upon exports for income. Agriculture is one of our biggest exports and if the rest of the world economy stays in the dump, that will start backing up into the ag sector. It's the major dark cloud on the horizon right now."

The COP states that U.S. ag exports declined 28 percent from a record high of $10.6 billion in October 2008, to $7.6 billion this past April.

In an email, Swanson and McCorkle said that, over the past two years, "agriculture and agribusiness have experienced unprecedented price, cost margin, and cash flow volatility. Such volatility is the new norm for the industry as we have linked agricultural commodity prices to the volatility of energy markets and increasingly exposed them to global markets."

This is how the industry works, though, says Cor Broekhuyse, executive vice president and regional head of Rabobank International-Americas. "That's how every cycle in agriculture is sorted out: Prices go down, people kill off dairy cows, they go into meat, so the production of milk will go down so the demand comes up again," he says. "It's rather deep this time, I must say, but it will come back. Same in the meat industry; this isn't a structural issue, it's a cyclical issue that will sort itself out by cutting production.

"People always have to eat," Broekhuyse continues. "There is a developing, new middle class consumer category in countries like China and India, where there is not a strongly developed domestic industry. So they will still rely a lot on imports from the Americas, not only the United States but Latin America. So maybe there is a dip now, but that is only temporary. I see long-term, good opportunity for farmers."

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