Lenders will need to pay close attention to their agricultural loan portfolios this year.
Banks, by and large, have had a good run with ag lending in recent years. Farm and farmland loans increased by 8% in the third quarter from a year earlier, based on data from the Federal Deposit Insurance Corp. Delinquency rates are their lowest they have ever been.
A confluence of issues, including low commodities prices, rising interest rates and falling prices for equipment and machinery, could put pressure on those numbers. A lingering drought could place additional strain on farmers and lenders in California.
While large crop yields helped offset low prices last year, banks and their borrowers cannot rely on bumper crops to address future problems. So farmers must find ways to trim costs, and lenders will need to continuously gauge their borrowers' finances.
"This will be a telling year for us as ag bankers," said Curt Covington, senior vice president of agricultural finance at Farmer Mac. "I think there are a lot of bankers … making sure customers are aware of the challenges. I think most bankers would say 2015 was a relief, but they're gearing up for tougher discussions in 2016."
In the past, farmers could overcome low commodity prices by diversifying what they produced, said John Blanchfield, a principal at Agricultural Banking Advisory Services. For instance, a corn farmer may decide to hold on to his crop if prices were too low and feed it to hogs and cattle.
Changes in technology and elsewhere have made it harder to diversify, Blanchfield said. Farmers need contracts in advance to sell livestock to meat packers based on a schedule. It can also be costly to make improvements to a farm so that an owner is able to grow other crops or raise livestock.
Farmers are witnessing a softening of asset values, mostly for machinery and equipment, reflecting a decline in demand for such items. This becomes an issue if the farmer has to borrow against the asset; declining market value limits a farmer's ability to leverage the asset, Blanchfield said.
Rising interest rates could eventually cause problems, industry experts said.
Loans for farm land typically have fixed rates, but operating lines of credit are usually short term and variable, said Steve Apodaca, senior vice president of the American Bankers Association's center for agricultural and rural banking.
Most farmers should be able to adjust since rates are already low and are likely to rise slowly, industry experts said. Other factors, including low oil prices, should provide a timely offset, said Roger Sturdevant, an executive vice president in the agribusiness banking division at Bank of the West.
"At this point, I'm neutral on rising rates," Sturdevant said. "Having said that, farming is a capital-intensive industry and higher rates aren't good."
California farmers have been especially hard hit because of a four-year drought that has depleted water supplies. To counter this, many farmers left some of their land fallow so they could focus on their most valuable crops, Sturdevant said. Recent rain and snow in northern California should help, though it won't reverse years of dry weather.
Still, many farmers, including those in California, have options to survive tough times, industry observers said. Borrowers that saved cash during the good years should be fine, and bankers should advise their borrowers to communicate regularly about their income and ability to repay loans.
Banks should also consider whether they will need to restructure loans to their more troubled farmers, industry observers said. This could allow weaker clients to stay in good standing despite a dip in revenue and higher borrowing costs as rates rise. It could also help banks differentiate by showing a willingness to be flexible during trying times.
"You don't win new business when it's all A credit," Blanchfield said. "You win business when you're willing to employ all of those things you learned to help you [distinguish between good] deals and those that don't have a future."
More banks will likely tap into government programs, such as loan guarantees for buying land and operating expenses through the Department of Agriculture, industry experts said. Lenders might also turn to Farmer Mac, which offers several programs, including one where it buys mortgages for agricultural real estate.
This could help avoid a tightening of credit, especially for farmers who are a "little more questionable in terms of cash flow," said Mark Scanlan, senior vice president of agriculture and rural policy at the Independent Community Bankers of America.
"Banks are in the business of making loans," Scanlan said. "In some cases, that may involve a safety net."
Despite a substantial drop in farm income, many borrowers of Lake City Bank in Warsaw, Ind., had strong operations heading into the commodity price downturn, said Joseph Kessie, a senior vice president and commercial south regional manager. Lake City, a unit of the $3.7 billion-asset Lakeland Financial, could still turn to government programs to help farmers restructure their operations during these leaner years, he said.
"Overall our client base is very strong," Kessie said. "Farmers as a whole are resilient and are in an excellent financial position, but everyone needs to remember there will be certain producers that need to make changes."