(Bloomberg News) When regulators come knocking at the Bank of Newman Grove, Nebraska, inquiring about loan risks, Chairman Jeffrey Gerhart has a "stress test" ready to show how his portfolio would fare if rural land prices dropped 25 percent. Or 50 percent. Or 75 percent.
"I hope it's not going to go to heck in a handbag out here, but this allows us to look at those worst-case scenarios," said Gerhart, a fourth-generation banker in the 800-person town two hours west of Omaha, deep in the heart of Nebraska's corn and soybean belt. He began stress testing his bank's assets, about 90 percent of which are agricultural, in the last two years after prodding from staffers at the Federal Reserve Bank of Kansas City.
Farmland prices in Nebraska rose 30 percent in the second quarter from a year earlier, according to a survey by the Kansas City Fed, driven by soaring farm income from elevated agriculture commodity prices and record-low interest rates. That's the high end of increases in cropland valuations of 8 percent or more throughout the region stretching from Oklahoma to North Dakota and from Nebraska to Michigan, according to surveys by three Federal Reserve banks. The Fed banks -- Kansas City, Chicago and Minneapolis -- oversee about three-quarters of the nation's farm banks.
Regulators and bankers like Gerhart are trying to use smarter policies and better information to prevent this asset price surge from forming what Yale economist Robert Shiller called his "dark-horse bubble candidate for the next decade."
Examiners at the regional Fed banks and the Federal Deposit Insurance Corp. are scrutinizing the lending standards, concentration levels, and loan documentation and risk management practices at the country's 2,144 farm banks. Risks that could curb the frothy farmland prices include a punishing drought in some states and volatile global commodity markets that could plunge and strip away crop income.
Low interest rates pose another threat, former Kansas City Fed President Thomas Hoenig has warned. Hoenig dissented against all eight decisions of the Federal Open Market Committee last year, citing concern that an "extended period" of near-zero interest rates could lead to a "build-up of future imbalances" such as asset bubbles, and create risks to "financial stability."
Shiller's warning has the Fed on guard, based on interviews with Fed regulators, economists and policy makers. His prediction of a national housing bubble in a 2005 revised edition of his book "Irrational Exuberance" proved prescient. Regulators missed the risks in residential and commercial real estate that led to a financial crisis, the longest and deepest recession since the Great Depression, 9.1 percent unemployment and nearly 400 bank failures since 2008.
That concern affects farm bankers like Gerhart, who employ new tools to help assess risk. "Stress testing is the buzzword of the last couple years," said Gerhart, who evaluates how his assets would perform in a downturn using a bank lending software package from WebEquity Solutions in Omaha, Nebraska. Gerhart's tests show that if land prices dropped 25 percent or 50 percent his bank's loans should not be negatively affected. A 75 percent drop would "have an impact," he said.
The risks of a farmland bubble have been highlighted in a series of sessions held by regulators this year. The Farm Credit Administration hosted a roundtable in February. The FDIC sponsored a "Don't Bet the Farm Symposium" in March. In July the Kansas City Fed organized a conference on "Recognizing Risk in Global Agriculture."
Attendees at the Kansas City conference included officials from the FDIC, the U.S. Department of Agriculture, the Office of the Comptroller of the Currency, Farm Credit Administration, and the Federal Reserve banks of Minneapolis, Chicago, Dallas and the Fed's Board of Governors. The group considered questions like what would happen if crop prices fell by half, if government subsidies for agriculture or ethanol disappeared, or if land prices tumbled by 30 percent or more.