The bar for getting a loan has been raised, thanks to the economic shocks of the past few years and the current surging cattle market. And while the recession affected agricultural loans less than other sectors of the U.S. economy, and cattle loans less so than other sectors of agriculture, cattlemen can still expect a different lending environment for 2011.
“The standards the last two years have ramped up,” says Danny Klinefelter, Texas A&M University (TAMU) professor and Extension ag economics specialist. He says that’s due to a number of factors that when combined, have eaten away at banks’ lending capital.
At the macro level, the economic shivers from the real-estate collapse heightened regulators’ sense of concern, he says. Then, because of the number of bank failures in 2009, FDIC premiums went up and banks were forced to pre-pay three years of FDIC premiums in December 2009 to cover bank failures in 2009 and 2010. “It primarily affected big banks, but it filters down,” says Klinefelter, who worked in the Farm Credit System before becoming a TAMU banking expert.
How we got here
Prior to the recession, banking regulators felt that banks, in an effort to reduce their taxable income, were building their loan-loss reserves to excessive levels. Since then, Klinefelter says banking regulators have done nearly an about-face by requiring banks to have loan-loss reserves that are more anticipatory. “All of a sudden, to meet the regulatory requirements, everybody has had to amp it up,” he says.
A competitive banking environment for most of the first decade played a role, too. Through most of the 2000s, lenders were so actively competing against each other that in many cases, they bid the risk premium out of the loan rate, Klinefelter says.
“You’ve got your base cost of funds, your operating expenses, and whatever you’re shooting for as a normal profit margin. But then on top of that, your risk premium is based on the level of risk perceived in the loan. And the competition heated up enough that a lot of that risk premium had simply been bid out.”
The bullish environment of the past decade is gone and won’t likely return, at least anytime soon. “We’re moving back into risk-based pricing, and lenders are differentiating a little more between types of loans,” Klinefelter explains.
Generally, Klinefelter says that means more emphasis by lenders on borrowers’ risk management, which may include a marketing plan, use of insurance or other tools to offset some of the volatility and risk that comes with simply producing a set of calves and then selling them on the cash market.
“You’re also going to see a much heavier emphasis on working capital and repayment capacity,” he predicts.
And it’s not just your current cash-flow situation. “Bankers have to look at the sustainable repayment ability, which really gets back to profitability and particularly accrual-adjusted profitability analysis,” Klinefelter says.
Bill McQuillan agrees. “We have to be pretty cautious with where the current cow price levels are right now, in my opinion,” he says about the cattle market. McQuillan, president and CEO of CNB Community Bank in Greeley, NE, says he’s loaned money on $600 cows and on $1,200 cows; in the volatile environment that characterizes the cattle market now, that’s cause for a banker to pause and think.
“We update our current customers’ financial information annually and run a cash-flow analysis. Similarly, prospective customers would need to qualify by utilizing their cash-flow analysis and showing an ability to repay,” McQuillan says.
For new customers or cattlemen looking to expand their herd, McQuillan says the number-one thing he looks at is their debt-to-asset ratio, ideally below 50%. In most cases, he also wants the borrowers to have at least 40% equity in the cattle.
“The more prices increase, the more concerned I get about the marketplace. I’m in business to help my customers for the long term. I don’t want them to get in so deep that they can’t survive a down market. That’s why, in this higher-priced market, I’ve gone down to 60% loan to value instead of our historic 65% to 70%.”
Klinefelter thinks that’s sound reasoning. He says nobody knows when the market hits its top or bottom, but everyone knows if the market is trending up or down.
“If you’re on an upswing, you don’t want to commit yourself close to the limits of your capital debt repayment capacity because both your lender and you know there’s likely to be a downturn before it’s paid off,” he says.
Most operations in McQuillan’s area of central Nebraska are diversified, with both crop ground and pastures. Herd size typically runs 50-100 head. If a borrower is running 50 cows with no debt and wants to expand by 10 head, that’s easily doable, particularly if the borrower can grow part or all of his feed.
“If you want to double the size of your herd, it’s probably going to be a challenge unless you bring some additional cash to the table,” he cautions.
McQuillan’s mantra with borrowers is to be conservative and patient. “I try to encourage all borrowers that the main strategy is to make sure you don’t get over-leveraged. If you don’t have all the money available now (to expand), save it and maybe do it next year.”
In the final analysis, he says, it’s a matter of sitting down with your banker and making sure you’re both on the same page. “If the cash flow and leverage ratio passes muster, then it’s a win-win for both.”
McQuillan’s conservative approach is common among ag bankers, particularly in today’s volatile market. “I think all lenders have pushed working capital much more,” Klinefelter says. From his perspective, if you’re looking to expand, you need to look for ways to lock in your marketing scheme.
“If I’m expanding, I’ll be paying that over three to five years. The lender has to measure whether you’re the type of risk manager who uses the proper tools so you’re not exposed as much to the volatility as the guy who’s just producing for the cash market.”
Borrowers can argue that the current upswing, given tight cattle supplies, is likely to stay around for a while, but what if something happens? “Any lender wants to see that you’re realistic enough to recognize things aren’t necessarily going to go exactly as you expect them to,” Klinefelter says.
So when you do your what-if projections in preparing to ask for a loan, the lender will want to see if you can support the numbers you’re proposing based on your previous history. “Then what happens if a heart attack, stroke, accident or divorce were to disrupt the management team? Do you have anything in place? That’s particularly true if it’s more than just a one-year deal,” Klinefelter says.
Nonetheless, if you come prepared, work with your lender and take a conservative approach, there’s money to lend, McQuillan says.
“It’s all about your balance sheet. If you’ve been able to survive the last 10 years, you should have a pretty good opportunity to expand if you have the cash flow and good equity in your cowherd,” he says.