NOV 30, 2012

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Compliance Matters

A Bubble to Remember—and Anticipate?

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Like the housing bubble of the 2000s, this bubble was fueled with debt provided by a government-sponsored enterprise: in this case, the Farm Credit System. As in the 21st century housing bust, the culpable GSE was bailed out by the government, which theoretically was not obligated for the GSE’s debt, but in reality was. With GSEs, the government always pretends that it and the taxpayers are not on the hook for their debt, but they always are.

One of the key factors in this bubble was the out-of-control general inflation of the 1970s, caused by the Federal Reserve under chairman Arthur Burns, whose hand was on the throttle, revving up the money-printing presses. Farmland was thought to be a good hedge against inflation, and it was better than that—until it was not. The shrivel of the farmland bubble in inflation-adjusted terms is much more dramatic: real farmland prices fell 38% from peak to trough, and in 1987 real prices were back to their level of 1972, 15 years before.

What did it seem like after the bubble turned into a shrivel in farmland prices and farm mortgage lending collateral? As one contemporary study, published in 1987, said, “Severe financial problems in agriculture have drawn a great deal of public attention.” (Of course, they have since been largely forgotten by the public, as is usual in financial cycles.)

“Land values have collapsed,” the study went on, “driving many farmers into bankruptcy and compelling foreclosure. The crisis has also heightened the dominant role played by the government in the market for agricultural credit.”

“The threat to agricultural lenders as a whole is enormous,” opined a 1986 article in the South Dakota Law Review. Failures of agricultural banks had increased rapidly by then. The threat also applied to the Farm Credit System, which in 1985 lost $2.7 billion, a record for financial institutions up to that time, and in 1985-86 had a two-year net loss of $4.6 billion, another record. One study reported, “Performing loan volume was dropping rapidly...nonaccrual loans were rising...interest margins were declining” and “the external auditing firm of Price Waterhouse [issued] a qualified opinion on the long run viability of the system.”

How perceptions, including those of regulators, change as one goes from bubble to shrivel. Thomas Stanton observes, “The reports of the Farm Credit Administration on the financial state of the Farm Credit System turned from rosy optimism in 1982 [at the peak] to a report of financial stress in 1984 and a request for taxpayer help in 1985” and then a major taxpayer bailout in 1987.

How had the former rosy optimism developed? As always, bullish thinkers found plausible ways to argue that the inflation of the bubble was based on fundamental developments. Farm income and prices had been rising strongly, and the price optimism was often based on global pessimism.

As discussed by Richard J. Herring and Susan Wachter, the investment literature of the time often displayed a “Malthusian Optimism hypothesis,” which “predicted that the demand for food would grow exponentially, but the supply of food would not...Thus, productive farmland in North America would become increasingly valuable.” This fit with the observation that “farmland prices had risen during the whole postwar era and...provided a rationale for ignoring earlier collapses in farmland prices.” Things were different this time! “The subjective probability of a collapse in farmland prices was treated virtually as if it were zero,” just as the probability of a house price collapse was treated a generation later.

Herring and Wachter go on to judge the Farm Credit System “the most aggressive lenders” in the bubble because they “increased their lending sharply as farmland prices began their ascent and continued to increase their lending three years after the peak.” Since the Farm Credit System is a GSE, “the creditors failed to discipline the risk-taking.” Farm Credit “placed a volume of bonds in the early 1980s second only to the U.S. Treasury,” based of course on the so-called implicit guaranty of the Treasury, which always turns out to be a real guaranty. “Holders of the bonds had little reason to monitor or price the risks taken”—and indeed that was true, for just like holders of Fannie Mae and Freddie Mac bonds in our own day, they were paid every penny of interest and principal due.

One of the most important government actions affecting the farmland bubble goes back to before it was inflated. “The real value of farm real estate began accelerating in 1972,” a 1985 study pointed out, but in the year before that, the Farm Credit Act of 1971 “allowed these banks to lend up to 85% of the purchase price of farm real estate, instead of the previous limit of 65%.” Thus, Congress promoted greater financial leverage in the farm sector, just as it did in housing, doubtless with good intentions.

"Real prices have been rising for 17 years, and if you are 40 years old now, you were only 10 when the last farmland bubble burst."

The farm credit crisis of the 1980s prompted legislation in 1985, 1986, and 1987. The 1985 Farm Credit Act Amendments set up a backstop line of credit for the Farm Credit System from the U.S. Treasury, making the link to the taxpayers clearer, created a “bad bank” to hold nonperforming loans, and restructured the Farm Credit Administration to be more of an arm’s-length regulator. But the crisis rolled on, according to one history: “farmland values continued to fall...losses continued to mount...[good] borrowers who were concerned about the security of their stock left the system.”

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