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Farmers eye interest rates
Farmers have enjoyed low interest costs since 2008 when the housing and financial collapse caused the Federal Reserve to slash rates to near zero.
But farmers should not take cheap money for granted, as rates will eventually rise. With interest rates low, by default the next move is up. Advisers suggest being ready for it.
For several years now, retired economics professor Edmond Seifried has been traveling the country to warn farmers of higher rates. But on August 9, he had to moderate those warnings when the Fed made the unprecedented announcement that it would hold interest rates “exceptionally low” through mid-2013.
“It was a two-year reprieve for farmers,” says Seifried, a partner in the Pennsylvania bank consulting firm Seifried & Brew. “I call August 9 Farm Freedom Day.”
The Fed's statement came just one day after the stock market suffered a sharp one-day loss. The message was meant to soothe jittery markets and instill confidence in the economy. The wording was unprecedented, say Fed watchers, because the central bank had never before used such a specific date. Typically, the Fed will merely say that it intends to hold rates low for “an extended period.”
“The announcement basically lifted the burden of worrying about a sharp rate increase that's surely coming in the future,” says Seifried. “Rates can't stay this low forever, and farmers should not get used to these low levels.”
In about 150 speeches a year to farm groups, Seifried warns that interest rates will eventually have to return to “where they should be.” He calls this natural rate equilibrium. An equilibrium level, he says, would be determined by free-market forces, without the artificial influence of the Federal Reserve.
“Farmers should not take cheap money for granted.”
Seifried warns farmers that the natural equilibrium rate for farm loans should be around 8% to 9%. That level is made up of three components.
1. Savers won't deposit their money for nothing; they want to be paid. Seifried suggests 2% to 3% as a minimum market-based rate.
2. Because loans are repaid in the future with cheaper dollars, interest rates have to account for inflation. That adds another 2% to 4%.
3. You have to add the lender's profit and overhead. He figures it all adds up to about 8% to 9% by the time it is lent to farmers.
As farmers entered this fall's harvest, ag loans were running around 3.4% to 5.3%, depending on the term and whether the rate was variable or fixed. Four years ago, rates were closer to 7%.
Maturity of government securities
With the Fed's August 9 announcement, it looks like rates will stay low for a while. But Purdue University agricultural economist Mike Boehlje warns that the Fed is not obligated to stick to its announced plan.
The Fed could raise rates at any time if employment and economic activity start to pick up. In fact, says Boehlje, the Fed would like nothing better than to raise rates, as that would be a sign of an improved U.S. economy.
“Interest rates will go up eventually,” says Boehlje. “Farmers should take advantage of this window of opportunity to lock in long-term debt at low fixed rates.”
And although mid-2013 seems far away, strategists for the four-state Farm Credit Services of Mid-America are already preparing for it. “It's definitely on our radar,” says Mark Hancock, vice president for finance.
In recent months, the Farm Credit System (FCS) has been actively notifying farmers to convert to lower rates, then securing the money for those loans in the wholesale capital markets. With crop prices high, Wall Street bankers see reduced risk in farm loans, and that means ag lenders can obtain loan money at lower rates.
At the farm level, locking in interest costs and refinancing to a lower rate is easiest for long-term loans on land, machinery and buildings. In contrast, protecting against a rate rise on short-term operating loans is more difficult.
One approach is to use a variable-interest line of credit with a cap (limit) to how high the rate can rise over the life of the loan. Such protection doesn't come for free, and an example of how the fees are imposed can be found in the table below.
Northwest Indiana farmer Brian Putt doesn't want to bet his farm's future on whether the Fed keeps its word through mid-2013. So in September, when his lender sent him an email outlining the benefits of refinancing, he refinanced. He locked up his machinery loan for seven years at 4.5%. And he got a lower rate on his long-term land loan by agreeing not to refinance for five years. “I don't see how rates can go much lower,” he says.
One final aspect of borrowing that needs to be addressed in a rising-rate environment is a shrinking credit line.
A banker who lent you $1 million in annual operating funds at 3.5% might cut that back once rates rise to 6%. It is best to discuss your credit line with your lender ahead of time.
Interest Rate Protection
The table below is an example of actual interest-rate protection that borrowers could buy earlier this year at some Farm Credit Services locations.
With a capped variable-rate loan, you could guarantee, by paying a fee, that your rate would never go up more than 1 percentage point over the next year. That up-front fee was 7 basis points, or $70 for every $100,000 of your credit line. But if you wanted to extend that same protection out to two years, it would cost $880 for each $100,000 covered.
Allowing your interest rate to drift up by 2 percentage points instead of 1 is cheaper. One-year protection for a 2-point cap costs just $20 per $100,000. Two-year protection costs $460.
Three-year protection, which extends beyond the Fed's 2013 commitment, costs $1,630 to $2,700 for every $100,000 covered. Fees change daily, depending on market conditions.
When it looks like the rate trend has changed to a rising environment, the entire fee structure could be raised to reflect the increased risk. That's important to know, because most borrowers would choose this protection only in a rising-rate environment.
“Most of our customers are fairly confident that rates won't increase more than 50 basis points (one-half percentage point) over the next year or so,” says Mark Hancock, vice president of finance for the four-state Farm Credit Services of Mid-America in Louisville, Kentucky.
Still, he says, the customer can get the best of both worlds with this approach: a lower initial rate, plus a cap. And if market rates go lower still, your variable loan rate goes lower too.
By Andre Stephenson