FARM CREDIT SERVICES

August 13, 1998

LENDING IN A CHANGING GRAIN ENVIRONMENT

Northwest Farm Credit Services is committed to providing sound and constructive credit to agriculture. Over time specific industries cycle downward, negatively impacting producers. Grain producers in the northwest, as well as the rest of the country, are beginning to experience the market impact of the present farm bill "Fair Act" and depressed prices. Most recently, the adverse impact has been accentuated for some areas by weather induced low yields.

Each time an industry experiences difficulty, some of the producers in that industry will not be able to survive and others will need to make significant changes in their operation if they are to maintain a viable operation. It is recognized each operation has a unique set of strengths and weaknesses. It will be critical to know the producer's production, marketing and financial strengths and weaknesses, and how those strengths and weaknesses will affect their ability to be successful in the current grain market.

The association is committed to the grain industry however, recognizes the industry and the association must adapt to the changes occurring in the industry. Those involved in the grain industry must respond to the long term challenges (decreasing government payments, world competition, the Asian financial crisis, and profitability) currently facing them. The association lending philosophy must reflect the problems and opportunities in the industries, which may translate to financing a smaller segment. This study will provide a few observations on current trends in the grain industry and provide the staff with lending guidelines to work through this portion of the cycle.

Some wheat operations have been able to build liquidity and reserves during the period of high wheat prices. Some of the profitable operations used excess cash to purchase machinery, retire debt, and/or expand the overall operation through the purchase of real estate. This group of producers utilized profits to improve efficiencies and improve their ability to withstand the inevitable downturn in the grain industry.

Due to a variety of different factors including high operating expenses, adverse weather, and basically poor management skills, some producers have been unable to make any significant progress. These producers enter a down turn in the industry in a weak financial state, or lack the resources to make the changes necessary. Some of these customers may be able to reduce operating costs however may not fully recover by the next down cycle. Others are burdened with excessive debt levels and inadequate production resulting in unrealistic and unachievable break evens. These customers cannot reasonably repay losses from future profits. Several producers also may be entering the downturn with the 1997 crop still in inventory. The continuing storage of the 1997 crop will put pressure on how the 1998 crop is stored and sold.

The following guidelines are intended to assist the association in financing the grain industries through the next one to two years. These guidelines are intended to be just that. It is impossible to establish a set of rules that could be reasonably applied to all producers across the board. The proposed guidelines cannot anticipate all possible alternatives and association staff must exercise good judgment. Each operation will have its own unique set of circumstances which will have to be analyzed. These lending guidelines will help the association assess the situation and work through this challenging time in the grain industry.

General Guidelines

1. Grain operations with VFP below $250,000 will have less than an average chance of surviving. An exception to this guideline, may be a diversified operation with grain income supplemented by a row crop program or livestock sources. Non-farm net income, rental payments received, and government payments should be given 2 to 3 times the value of farm income when calculating VFP equivalency for this guideline.

2. Family living should not exceed 10 percent of VFP. It will be difficult for two families to generate a living from a $250,000 VFP operation.

3. We can expect collateral to be less of a weakness than has occurred previously when the industry struggled through low prices. Debt set asides or write-offs will be difficult with strong collateral. The sale of capital assets may be a more viable option than it has been in the past unless the downturn in price becomes extended resulting in severely depressed land prices.

4. Capital purchases must be minimal if not completely curtailed.

5. Estimated losses can be determined in the following manner. Complete a projected earnings analysis at least through 1999. This projection needs to be added to the previous years' (those with losses) to determine the total operating loss.

6. It is critical that break evens be calculated for each operation. The calculation should include the amount of the principal payment plus the negative working capital or carryover debt termed out.

7. The operation needs to absorb as much of the loss in the short term as possible. Restructures of losses should be contemplated when we can be fairly certain of the total loss and the operation is clearly shown to have the ability to retire the debt. The association needs to be proactive, however, there may be only one opportunity to restructure an account.

8. Loans should be limited to about 65 percent of the appraised value of the assets. It should be recognized that in many instances, the income generating capacity of the underlying collateral may be inadequate to support the assigned level of debt.

Specific Guidelines

NWFCS has elected to take an aggressive posture and be proactive in its approach to the current price challenges in the grain industries. Each operation has its own unique set of circumstances and will need to be analyzed as such. Early problem recognition is crucial. Once the problem is identified then appropriate steps can be taken to either correct, collect, or leave as status quo.

The following specific guidelines will assist the staff in meeting the association objectives. The primary objective will be to pick the right customer with a solid, well-structured operation and financial strength. The minimum criteria includes:

Debt/asset ratio less than 30% but no more than 40%.

Term debt not to be more than double VFP.

Operations exceeding $250,000 VFP. (Applicable to straight grain operations. Other income sources could supplement the income from grain.)

Customers are to be categorized by their ability, or lack of ability to meet the challenges of the changing grain market cycle. Class 1 & 2 customers must be qualified by meeting the minimum criteria above.

Class 1 (Qualified) These customers will be able to make payments and absorb the loss due to adequate working capital, room in their operating line, or other crops or livestock and options available to subsidize the losses.

Class 2 (Qualified) Estimated loss could be termed or loan may need to be restructured. This scenario assumes that after loss is realized, it can be reasonably paid by $3.25 to $3.50 wheat (net to grower) over a 5-6 year period.

Class 3 (Non Qualified) Estimated losses cannot be reasonably termed out even though progress has been made in good times. Need to work with these customers on alternatives.

Class 4 (Non Qualified) No progress in the good times. Need to find resolution and exit relationship.

If qualified:

Option 1 If FCS only has the term debt:

(a) Reamortize and delay payment up front to give working capital for operation. Be sure and check the collateral position prior to loan servicing,

or;

(b) Provide operating loan to make term payment only if the customer meets the criteria of Class 1 and 2 qualified customers and the customer has no other operating lender. Either extend carryover for no more than 2 years once the cycle ends or term out when downturn ends.

Option 2 Same as Option 1b. if FCS already has the operating and term relationship.

Option 3 If operating only, carry for no more than 2 years if the customers can recover operating losses and margin their loans at the end of two years, or term out (maximum of 5-6 years) to give margin up front.

New Loans

The lower prices in the grain industries may provide some opportunities as well as challenges. FCS may have opportunities to pick up loans from commercial banks or other traditional and non-traditional lenders disenchanted with grain loans. It is crucial to focus on the philosophy that growth must come from good loans and not marginal loans. All new loans must meet acceptable qualifications such as: debt/asset ratios of less than 30-35 percent; term debt of not more than twice the gross income (can multiply the non-farm income by two to equate that income with VFP); sufficient size and scale to be an economic, viable unit and the L/CV ratio should not exceed 65 percent. Operations with solid historical earnings and good reserves should clearly be considered. All new loans must meet Class 1 or Class 2 qualification.

Investigation of new prospects will include a thorough understanding of their financing, production and marketing characteristics. The following are some reasonable questions to ask of new customers and are questions that prospective customers should be able to answer.

Is the operation of sufficient size and scale? What is the trend, i.e., is the operation growing, stable or shrinking? What is the break-even for the operation?

How many families are dependent upon the operation for a living? Is there any influence from non-agricultural sources?

If the operation is considering expansion, do they have the labor and management necessary to successfully complete the project?

Does the customer have any options for vertical integration?

What are average yields?

Is the operation dependent upon leased land for a base of operations? Are these tenured long term leases or is the customer subject to large acreage swings every year based on the ability to obtain the land leases?

Does the producer have a good record keeping system? Accountant prepared financial information is desirable if the operation is grossing over $1.0 million.

What is the producer's marketing program? Does the producer forward contract, hedge, use options, etc.? Does the producer have outside contacts for assistance (broker).

Does the producer consistently produce a quality product? If malt barley, have they met standards in recent years?

Does the customer have on-farm storage for the entire annual production? If not, is off-farm storage used or is the crop sold from the field?

What risk management practices does the customer participate in: MPCI, hail insurance, fixed rates on interest (to not be subject to a rate shock)?

Does this customer produce for a niche market? Is the producer keeping up with new/ improved varieties?

Does the producer have a "low cost producer" mentality? This encompasses operating expenses and also land rent costs, equipment needs and living expectations.

If produced under irrigation, are water rights perfected? What is the customer's water priority rights (subject to abandonment in below average moisture years)?

What is the customer's mode of moving the grain to market? Truck, rail, barge, etc. Is it reliable and cost effective?

Summary

The next few years will be challenging for both lenders and grain producers. As with most activities, there will be winners and losers. Winners will be those that can quickly adapt to rapidly changing market conditions. FCS fully intends to continue to provide sound, constructive financing for grain producers.