Ahead of the curve: A banker’s podcast episode 6 – Ag lending

Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

~music interlude~

Thomas Curley 0:11

Welcome to this episode of Ahead of the Curve: A Banker’s Podcast, I’m your host Thomas Curley and I am here with Rob Newberry. Rob is a veteran of the podcast so far and so we’re excited to have him back on. He’s a Senior Advisor on Abrigo’s Advisory Services team and he’s currently a faculty member at the Graduate School of Banking at the University Of Wisconsin Madison. And over the last ten years he has been focused on working with financial institution leaders and regulators to develop a suite of credit administration tools for financial institutions and maybe most importantly for today’s conversation, I know he grew up on a dairy farm.

Rob Newberry 0:52

That’s right Thomas, yes. That’s why I’m an ag expert, I milk cows for many years. Glad to be in the business world not on a dairy farm.

Thomas Curley 1:04

Well we’re certainly excited to have you on the talk ag lending. I know it’s a bit more niche topic than some of the ones that I know you’ve jumped in on in the past, but I think it’s an important one especially for many community financial institutions out there. So I wanted to jump right in and Rob, you know, I know we’ve got high inflation across the board potentially meaning, you know, some high input cost. And my assumption is that there might be some increases in loan demand for ag banks. Is that kind of true on your end? You know what’s going on in the market?

Rob Newberry 1:35

Yeah, so a couple things going on with that comment. The first one being, yes, eventually it will definitely lead to more loan volume. Now it’s one of the interesting things about the pandemic and the stimulus packages. I think maybe ag was, I’m gonna say, a little overstimulated by government direct payments. Which did a couple things, hopefully ag producers were able to pay down their debt load or debt carry which would make it easier for you to give them money going forward and make the credits have less risk. However because they got government subsidies and then commodity prices also went up at the same time as kind of like a double whammy where they were liquid with cash and really have been able to absorb to this point a lot of the increases in expenses. So kind of think of it this way, a lot of them prepaid some of their expenses for this year last year because they had some direct government payments and commodity prices were good. So the real impact hasn’t really hit a lot of the ag producers, but it is coming for sure.

Thomas Curley 2:50

Awesome! And then I know we’ve got a lot going on globally, which I think more than other industries affects the ag space, you know, any comments on the war in Ukraine or any other of the economic issues and how that might play into some of the banks and credit unions out there in the ag space?

Rob Newberry 3:09

Yeah I mean there’s a couple things going on specifically with the war in Ukraine is we get a lot of our fertilizer from Ukraine or were, so that price even for the non ag producer if you were just a homeowner going to buy fertilizer’s doubled or tripled in price just for a bag of it right? And so significant increase in fertilizer and then we have the oil issue right? And so Russia being a big oil supplier as we cut those ties the cost of fuel has exploded as well. So, two of the main inputs for ag have had the highest inflation and so kind of get this double whammy of, you know, fertilizer going, up gas prices going up, and with the also with the increase in interest rates. Thomas I’m not sure you’re probably aware that we had a significant increase just the other day. First time since the mid 90s I think that interest rates were hiked by 75 basis points.

The other main input a lot of times on ag is interest expense, so 3 of the biggest expenses have all significantly went up and so we have those things kind of going on in the ag landscape. Commodity prices are up so one benefit that we will see is because Ukraine’s not producing grain right now, the demand for a grain will go up. So commodity prices still should stay up. I think I read an article yesterday that they anticipate commodity prices at least through next year kind of being 5% higher, so pretty steady or higher which is good. But I guess the biggest concern I kind of have with that Thomas is with the high input costs. You know we were able to take advantage of that in 2021 and 2020. The flipside is and we’ll have high input costs and then when the commodity prices drop, we’ll be caught on the backside of that and that’s when a lot of folks will get in trouble. So if you remember back in 2019 and that’s the last time interest rates were this high, farm income was not very good right? I mean that was some of the ag stuff was getting pretty tight, not a lot of profitability and then COVID hit and things significantly changed. Now we’re kind of back to where we were March 3^rd, 2020 is when prime was 4.75 so exactly where we were before COVID from an interest rate perspective.

Thomas Curley 5:36

So what you’re saying is we should go and dust off some of those old white papers and blogs from 2019

Rob Newberry 5:42

Yeah absolutely, you know, and it’s interesting because, I think maybe you’ll ask me a question about how the 80s and ag crisis ties into now and, you know, one of the things that, a new term, it’s not a new term, it was back in the 80s to it’s called stagflation. Which basically means where we’re having inflation but our GDP is actually declining. So typically when you have inflation that means our economy’s booming in, you know, where it’s more expensive to do things because we have to pay more money for people to work and everything’s going great. We’re kind of in a unique situation that we have inflation and after the pandemic and you know now we’re raising interest rates to also shutter GDP that we have stagflation which is we have not enough supply but the demand isn’t really growing. And so that supply chain issue still, we’re still dealing with COVID issues, and we have you know microchip issues and we have all these other things still going on it’s interesting. Stagflation was also in the 80s ag crisis, it’s kind of, was one of the leading causes that created that issue back in the 80s so.

Thomas Curley 6:51

Yeah, no, we’ll definitely talk a little bit more because I wanted to get your thoughts on, you’ve written a white paper for us recently and I wanted to get some of your thoughts on that. Before we jump off the state of the ag landscape, always like to ask as I’m reading other ,you know, articles across the industry they’ll sometimes call out specific regions or maybe dairy farmers or ,you know, corn specifically. Are there any sectors that you think present a unique opportunity or maybe areas or vice versa? Maybe something to look out for from just some of the data that you’ve been seeing.

Rob Newberry 7:24

Yeah, you know, the only thing I saw that and it really didn’t concern me I mean steer so like livestock pricing looked like it was going to be level or down a little and with the high input cost of corn right? So when commodity prices of corn is high, it’s more expensive to feed your cattle. So if if the cost that the producers are getting for cattle is actually going to decline a little and their input costs are going to go up, there might be a little concern in the cattle lot. You know, cattle, cattle feeder, lot, ranch issue. The only other issue Thomas is with high input costs just commodity prices in general. If we take a dip in any of them just with a high input cost, it could lead to some significant issues rather quickly right? Just because everybody will be flipped upside down pretty quick.

Thomas Curley 8:18

Gotcha. And I guess that probably leads into the next question I had. We alluded to at the top end about, you know, will some of this stuff lead to increase demand given some of the stimulus that they’ve had and been able rely on the past couple of years. Do you see that being a something that’s gonna happen real soon or something that might still, like you said, is still being delayed a little bit? It might take some time to catch up.

Rob Newberry 8:42

Yeah I would anticipate that the volume will start picking up next year. So the next ag cycle. We’re kind of, you know, we’re, I’m in the Midwest here Thomas, you’re aware of that but you know we got all our crops in so we’re through that phase of the lending cycle. Once they get those crops in, depending on commodity prices I think next cycle you’ll see a lot bigger demand for loan volume because of the high input costs. Folks won’t want to prepay their expenses like they did previously coming into 2022 and I think you’ll see ag demand significantly increase going forward. So I think most folks have probably burned through the stimulus and their liquidity getting to where they’re at now in that we should see an increase in volume in 2023 as we start the ag cycle again.

Thomas Curley 9:37

Great and I think that that’ll be some good news. Obviously there’s always some nuance to that as I know obviously we don’t love inflation and some of the other things that come with it. But I think some good news for financial institutions out there.

Switching gears a little bit and we’ve already talked a quick second about the 1980s farm crisis. You wrote a white paper that had a little bit information in there and I wanted to get your thoughts on how you see the current environment similar to the 1980s. What should lenders be keeping an eye on based on your experience?

Rob Newberry 10:10

Yeah, a couple things. One is there’s always folks that chase hot deals. When commodity prices are high land values go up, so we’ve seen a significant and increase in land values. So then people that want to buy the land have to buy it at the highest level. That with high interest rates make that a lot riskier because if the ag land is elevated and then comes back to more normal pricing folks will feel like they are underwater right in their current purchase. So it just makes that debt load a lot heavier for them to carry as you go forward. And so Thomas that’s one of the big concerns and that’s what happened in the 80s was, a couple things. One is commodity prices drop but farmers had a lot of inventory. Well in order to survive they had to sell their inventory and that was what was backing up a lot of the loans. So then all of a sudden there were a lot of loans that were basically unsecured because they had sold the inventory underneath the bank without the bank being aware of that. The only good news is usually in inflationary time real estate’s a good thing to hold because the values go up. Now, the bad thing is if it’s a bubble and prices come back down, you maybe paid too much and if you’re paying ,you know, the current interest rates that have went up significantly in the last two months you can get caught on the backside of that. And that’s kind of what happened in the 80s.

Thomas Curley 11:36

Gotcha. One thing I’ve heard you talk about is risk scoring models. Are there some strategies that you think folks start to implement to mitigate the potential of some of those things from happening in their ag portfolio?

Rob Newberry 11:49

Yeah there’s a few things. And so unfortunately inflation hits the ag industry in a couple ways. If it’s a family farm you have it hitting you kind of double. You have your living expenses, a lot of times when we talk about credit analysis for ag we do what we call a global analysis, which means we’re gonna look at the farm income and the personal income and use that combination to qualify the borrower. Well if you have high input costs and inflation, so your living costs also go up and you’re using the same source of revenue to cover that it’ll squeeze that credit and, you know, the other big thing we have going on right now Thomas is we have CECL going on. So we have third and fourth quarter this year where all folks will be trying to implement CECL. Depending on the methodology they pick if they pick like a default loss given default method, right, and they do like what I would call loan grade migration, understanding that changing in that credit grade based on some of these things that we’re talking about will also have an impact on the amount they’d have to reserve for CECL. So, you know, that probability of default method is one of the methods I’m sure several institutions are probably using in that and so that’ll be something to be aware of on that front as well. The other thing is understanding cash flow right? We know that as interest rates go up that’s one of the major expenses, making sure that the borrower can cover both interest and expense on that front will be critical. And just watching, I think what happened in the 80s Thomas to go back just a second is a lot of times we didn’t have the due diligence. We knew they had inventory but we really didn’t check to see if it was still there. I think keeping our eyes on the ball a little more this time and so if we do get things a little tighter making sure if we do have inventory as collateral, we know that it’s there and we actually look at it. So if it’s a tractor, is it a pedal tractor is it a real tractor right? Understanding what is really the collateral behind some of those notes.

Thomas Curley 13:58

And you mentioned, you know, land is always a good asset to have typically during inflation periods. But obviously if there’s some sort of bubble, there could be something wrong with that. Anything that they should be doing on the pricing side or anything of that nature to be ready for any potential risk on something like that happening?

Rob Newberry 14:19

Yeah there’s a couple things they can do on pricing. Glad you ask that question Thomas. Really two things come to mind. Typically in a raising rate environment, we do a couple things right? We kind of were afraid of interest rate risk as bankers, so we typically want to go short and when you do short-term loans you’re working in the narrow part of the net interest margin band. So, you know, usually you don’t charge as much for a 1 year commitment as you do a 15 year mortgage because you have that interest rate risk. Well if you’re always working in the narrow band and your cost of funds goes up, you just have a less opportunity to make money as a financial institution. So one of the things you can do from a pricing perspective specifically if you’re competing with, you know, Farm Credit and some of the other government-backed agencies is you might want to consider going a little longer in your product. Offering products that give the customer a little protection as well from a fixed rate perspective. So I’ve seen a lot of ag clients that do like a 1 year fixed line of credit basically or a loan, but you know the spread’s very narrow on that instead of doing a 7 year, you know, 25 balloon or something. And so trying to understand maybe your product mix and creating features that the customer will pay up for that protection that they get from a credit risk perspective can be huge as you go forward in a raising rate environment because I don’t think rates are done moving up Thomas. We talked about, you know, the name of the podcast, ”Ahead of the Curve.” The curve’s still going up right? So there’s probably still a couple more interest rate hikes out there. And trying to understand how to price those will be critical to maintain your profitability as a financial institution.

Thomas Curley 16:13

Gotcha and I think you’ve already alluded to this a little bit but I know one thing that Abrigo from a software perspective is really trying to help people make smarter loans and be able to catch things if something starts to go bad. Are there any tips or tricks that you would maybe want to let the audience know about how to identify those problem loans before they get to that point, especially with an ag lens there?

Rob Newberry 16:40

Yeah there’s a couple of things you can do and I know a lot of ag folks might not be aware of thi,s but there are specific business codes even related to ag. So there’s not one ag, you can get as specific as corn farming, you know, honeybee farmers. You can get very specific in those NAICS codes. So one is understand your concentration risk and do stress testing. And so whether it’s, you know, we’re in a raising rate environment, what happens if their debt service coverage changes by 25%, can they still make those payments? Is the first thing. The second thing I would say is proactively manage your portfolio. So knowing that, you know, as financial institutions we’re typically a little leery of interest rate risk. We probably have a bunch of folks maybe resetting here in the near future. So if you had a operating line or you had a three-year balloon or five-year balloon, you might look to see if they’re a good credit can you take advantage and maybe you refi them a little early to take advantage of the interest rate cycle. If you look at this, at the interest rates today it only cost fifteen more basis points from a two year treasury to a ten year treasury. So very flat from two to basically thirty years is almost the same interest rate, so it doesn’t really cost you more money to go longer. It’s more convincing your board and forgetting all that stuff we said that was really bad about interest rate risk and actually booking some longer term fixed product on your books. Which one, is it improves your pricing, two, it reduces the credit risk a little because you’ve locked them into a rate, so if rates go up in general but your farmers are locked in at 5% versus moving it at up to 7% there’s that more ability for them to make profit because you’ve already got them locked in.

Thomas Curley 18:35

Awesome. Well so the intention was to hit on some of the the top concerns for ag bankers for sure throughout this podcast and so we’ve hit on the market just generally, globally. we’ve hit a little bit on the inflation, the rising rates, and some of the credit risk. One things that always pops up when I look at surveys and other resources that ag banks are worried about are competition right? And we mentioned Farm Credit, but what are some ways you’ve seen clients stand out in the ag space as it’s getting more and more competitive as we go each year.

Rob Newberry 19:10

Yeah I mean there’s a couple reasons for seeing that right, Thomas? One is there hasn’t been a lot of loan demand so you’re fighting over table scraps right, currently. So it gets pretty competitive in that space. A couple ways that some institutions can separate, I’ve seen them separate themselves, is one is try to avoid what I call commodity pricing on your loan products. Don’t offer the exact same product that all the banks around you are offering because then you’re going to get rate shopped and that that hurts everybody, right, because you’re only as good as the lowest person in your community or vicinity and you’re kind of at their mercy. But if you can create products with either features that people are willing to pay up for, one is even if it’s the same price if you have a different feature you might attract customers that you wouldn’t normally get and be able to close a higher rate because you have other features. Specifically knowing that we’re in a raising rate environment, once again giving them some long-term protection is probably a huge win. But even if it’s maybe a little lower rate but charging a origination point or letting them buy down the rate a little, you know, simple things like that Thomas that can separate yourself from, you know, everybody selling table salt would be a huge win I think for customers. The other one is just be proactive with your customers right? Understand we’ve just went through the pandemic, so a lot of them probably had some stimulus money but kind of understanding where they’re at and being proactive as you manage their portfolio so you don’t lose good customers that you have. So there’s attracting new customers to get growth and there’s maintaining the ones you have, so trying not to lose the ones you have.

Thomas Curley 20:55

Awesome! One question I had and I was wondering if, you know, I midwestern banks we’ve got a lot of producers and farmers out there that they like going into the branch but I was curious on if you’ve seen a huge shift towards technology, really digital application type tools at some of these ag banks and if that’s another way to start to differentiate too?

Rob Newberry 21:17

Yeah, you know it’s interesting Thomas because the pandemic I think’s taught us all whether you’re an ag farmer or you know us Thomas that we can work remote and be more efficient and especially with rising input costs and all those things. We’ve had this request multiple times of being able to have ag customers submit their financials electronically, being able to input them themselves and do all kinds of fun cool things, or being able to sign online. So, you know, if you can be in the field and not at a bank, you’re probably more efficient. So technology is definitely playing a role. not only there but you know think of all the automated machinery equipment that’s controlled by GPS right? You don’t even have to really drive your combine anymore it drives itself and so technology is becoming a bigger and bigger role in ag and I think some of the farmers that are a little longer in the tooth are starting to understand that piece. And we also have kind of a new generation of farmers coming in that are used to that type of technology, and if you don’t have it will be disappointed and probably bank somewhere else. So you have this kind of niche of some older folks finally getting to understand the importance of technology and newcomers expecting it and if you don’t have it, they’ll find someone that does. A couple ways technology is impacting them.

Thomas Curley 22:41

Yeah I think the beauty of what you were just talking about is that by having the technology doesn’t mean you have to use it for every single customer or producer that you’ve got. You can, you have the opportunity if that’s what they want to do but they can still come into the branch if needed. So it’s just a nice to have those options when you need it I think.

Rob Newberry 22:58

Ya Thomas if you look at it the opposite way, it could be a deal killer if you don’t have it right? But it’s not a, you know, that doesn’t necessarily mean they’ll use it. But if you don’t have it and you have once again as farms turn over to the next generation, that generation’s grown up using their phone to do everything right? And so if you don’t have that ability you’re going to lose out just because you don’t have that ability. Not that they will use it every time because they might come in the institution or you might need the technology to go out and see them instead of having them come in the branch. Can you go out there with technology and iPad or something else and digital signature and do some other things that are pretty cool versus them having to come in and sign a paper.

Thomas Curley 23:41

Good things to keep in mind for sure. So, I want to go ahead and start wrapping up our time here. If listeners take, you know, anything away from the conversation I was curious if you had maybe two or three main points that you’d want them to think about after the call keeping in mind we’ve got you know financial institutions across the United States with ag portfolios listening in.

Rob Newberry 24:06

Yeah, a couple things. One is, you know, don’t panic, the loan volume will come back. And so I think to your point earlier Thomas about the credit risk, making sure that your model is updated and that you understand that, you know, with high input costs the risk is commodity prices falling and the profitability of those customers going forward in inflationary times right? So that would be one. One is also, I would say do the due diligence whether it’s when you’re doing the credit and looking at the collateral or whether it’s managing your loan portfolio and trying to catch things before they go south on you right? Trying to fix things as you go. And then I guess the third one is, it’s okay to say no, so don’t fight over the table scraps that might not be worth fighting over. So we talked about, you know, there’s not a lot of loan demand right now. However, that doesn’t mean you should go try to chase every deal and either make no money on it because you’ve offered such a low rate or you pick up customers that you normally wouldn’t have done based on your credit policy just because you’re not having any loan demand. So, if it’s a bad loan, it’s a bad loan so, you know, just because there’s not any good loans out there don’t pick up the bad loans. If that makes sense Thomas.

Thomas Curley 25:30

I think that will do it for our episode today. For those that are new listeners or those that haven’t subscribed yet, you can find this podcast and future episodes on abrigo.com or you can find it on your favorite podcast app or platform. You can search Ahead of the Curve: A Banker’s Podcast or simply Abrigo. Thanks so much for listening and we’ll be back again with our next episode soon. And Rob, just want to thank you as always for joining us and talking a little bit of ag.

Rob Newberry 26:01

Thanks Thomas for having me and look forward to talking to you and everyone again soon.

~music interlude~