BROADCASTER ARCHIVES

The Collateral Factor in Farm Business Management
By Amber Bennett, Sr. VP – Credit Delivery, Badgerland Financial

This article was printed in the July/August 2010 issue of the Organic Broadcaster, published by the Midwest Organic and Sustainable Education Service.

In previous articles I discussed the first three “C’s” of the “Five C’s of Credit” – Character, Capital, and Capacity. Next we will examine the fourth “C” – Collateral – as it relates to agricultural lending practices and sound farm business management.

Collateral has become an area of particular interest over the past two years as economic turbulence has rocked the banking industry and real estate markets across the country. Closer to home, exceptional volatility in farm input costs, milk prices and feed and grain prices have made commodity price prediction and selection of appropriate price protection much more challenging. When farm businesses endure challenges associated with marketplace volatility, start-up or expansion, or a course change in enterprise mix, collateral becomes a very important component of a loan contract.

• Definition of Collateral: The Merriam-Webster’s Collegiate Dictionary (11th edition) defines collateral as “property pledged by a borrower to protect the interests of the lender.” Collateral is also referred to as security; therefore, a chosen asset secures the loan for the lender. When a borrower applies for a loan, typically the asset being purchased will be pledged as collateral to the lender. However, in most cases lenders prefer to have a greater amount of collateral than loan amount. Thus, other assets can be pledged as collateral, as well.

Depending on the nature of the business and the volatility of the industry involved, typical loan-to-collateral values can range from 50-100% with most settling in at 65-70% for farm businesses and even non-farm businesses. In essence, the lender has a 30% cushion built in on the pledged assets, allowing for volatility in market valuation of that asset over the life of the loan. As an example, a dairy cow may be worth $2000 at one point in time, and then a year later it may be worth $1200 or vice-versa. The same can be said for most agricultural commodities, farm equipment and even real estate. Asset values can and do fluctuate over time, dependent upon market conditions and the ability to turn a profit. Thus, a lender is likely to require more collateral than the amount of the loan being requested.

• Why Collateral? Even though a lender may require collateral on a loan, I can assure you it does not want to own that asset at any time during the loan contract. In other words, farm lenders have absolutely no interest in actually owning farms, equipment, livestock or crops. Rather, collateral is used to help protect the lender’s various stakeholders from financial loss, including owners or shareholders, board of directors and management, other borrowers and the communities it serves. While lenders do their best to assess operational and marketing management, financial performance and the risk management aspects of the particular farming operations involved, the reality is that even the best-laid plans can go wrong. Regardless of the farm business model involved, often times human frailty such as death, divorce, disability or dissolution are the cause of a failed farm business.


• Types of Collateral: Collateral comes in all types of assets associated with a farming operation, such as bare land, real estate improvements (homes and outbuildings, commodity storage facilities, livestock facilities, etc.), vehicles (trucks and trailers), farm equipment of all types, breeding stock, market livestock, feed inventories and growing crops. A good rule of thumb is that the loan amortization or schedule of repayment will be less than the useful life of the asset being purchased or pledged as collateral. In other words, an asset should be paid off before it’s worn out or ready to be traded. Lenders have various ways to confirm value of collateral, including asset inspections and discussions with the borrower, consultation or contracting with a certified appraiser, consultation with sellers of similar assets, and researching comparative sales data from farm equipment guides and recent auctions.


• Maintenance & Management of Collateral: As part of most loan contracts, the borrower has several obligations as it relates to the care, use and disposition of collateral. These specifics can be found in the fine print of loan and security agreements, so be sure to read this information and understand what it means before signing loan documents. If you are unsure or if you have questions, be sure to contact your lender at any time during the loan contract.

Typically, adequate property insurance is required to be in place to cover the value of the assets involved. The lender may request that its name be listed on the farm owner’s property insurance policy to ensure that if something happens to the collateral, a joint discussion will occur about potential replacement of the asset or repayment on the loan. The more perishable the asset, the greater the need for insurance. Thus, cattle, crops and feed involve shorter loan repayment terms and a greater need for property insurance, particularly crop insurance. There are federal sign-up deadlines for most crop insurance policies so be sure you understand what crop insurance coverage you may need and when to sign-up. Again, when in doubt, ask your lender. Also, never sell or significantly modify collateral without first obtaining consent from your lender. Failing to do can be considered an act of loan default. Selling collateral assets typically requires an immediate payment on a loan contract (but not always), so talk to your lender first.

The collateral factor is sometimes the least discussed area at the time of a loan request, but it can be an important area to address, creating greater understanding of the lender’s and the borrower’s expectations and decreasing potential misunderstandings during the life of the loan contract. As always, communication is key in matters involving collateral and any loan contract.

Amber Bennett is Vice President- Farm & Home at Badgerland Financial, serving farmers and rural communities in 33 counties of southern Wisconsin. Amber works with a team of lenders who specialize in serving the unique, financial needs of full-time farmers, part-time farmers, and rural homeowners. She grew up on a dairy and livestock farm in southwestern Wisconsin and has 18 years of agricultural lending experience. She received a Bachelor of Science degree in agricultural economics from U.W. Platteville and an MBA from U.W. Whitewater. For more information, check out www.badgerlandfinancial.com.