Agricultural Loan Underwriting

Comptroller of the Currency

Agricultural Lending Handbook

December 1998

and

May 2014

Agricultural lending involves some unique requirements, however, the same fundamental underwriting practices as other forms of commercial lending apply.

The underwriting process, and subsequent loan administration should be governed by an effective set of lending guidelines.

What do we mean by “underwriting standards?” The term “underwriting standards,” refers

to requirements, such as ones related to collateral, loan maturities, pricing, and covenants, that banks establish when originating and structuring loans.

The Comptroller’s Handbook lists the following minimum underwriting guidelines for agricultural lending. In-depth financial analysis Evaluation of budgets and projections Sensitivity analysis as part of cash flow

analysis Structuring loans in accordance with the

type of borrowing and the expected income stream

Reliable collateral evaluations and margins, and/or other steps to minimize credit risk

Effective ongoing monitoring practices, including segregation of any prior period crop carryover debt

Thorough evaluation of the borrower’s character and history of managing debt repayment

Financial Analysis

Quality of financial information for agricultural operations varies significantly

In general, many small farm operations use cash-basis tax returns and market-value financial statements that are self prepared and unaudited

Key Elements of Reviewing Financial Information Review the reasonableness of budget

assumptions and projections Compare projections with actual results Assess working capital adequacy Analyze net worth changes Assess the impact of capital expenses Evaluate any supplementary sources of

income

Loan Structure

It is important to structure loans based on the purpose for which the loan is made

Short-term loans Long-term loans Carry-over debt

Short-Term Loans

Most often short-term loans are made for production inputs

Short-term loans are self-liquidating at the end of the production cycle from the proceeds from product sales

Long-Term Loans

Commonly referred to as “term” loans Primarily associated with the purchase of

capital assets, such as machinery and equipment, real estate, breeding herds and orchards

The primary source of repayment is from cash flows from operations

Collateral is viewed only as a contingent secondary repayment source

Carry-Over Debt

Refers to restructured short-term debt, such as the unpaid portion of an annual operating line of credit, resulting from the borrower’s inability to liquidate the debt as originally planned

Collateral Valuation and Documentation Collateral may be defined as property

pledged as security for a loan or other obligation

The pledge of collateral adds safety to the loan, since the lender may sell the pledged property to obtain payment if the debtor fails to pay.

For collateral to be acceptable to a lender the following requirements should be met:– Identifiable– Relatively nonperishable– Be able to establish a reasonable estimate of

value– Be in a saleable condition– Must have an established market

Collateral Evaluation

Current values of all collateral should be established when the loan is made

Periodic re-evaluation of value should be practiced, with the frequency of re-evaluation depending on the price volatility of the assets

The documentation of collateral values should include:– The location and identifying details about the

collateral– Fair market value, as of a specific date– The source of, or basis for calculation the value

estimate

Lien Perfection

A lien is a charge upon property for the purpose of securing the payment or discharge of a debt or obligation

The method of obtaining and perfecting a security interest depends on the type of collateral– Chattel– Real Property (Real Estate)

Chattel – An item or article of personal property, such as livestock, crops and equipment

Real Property (Real Estate) – immovable property such as land, buildings, improvements, and appurtenances

Chattel Lien A chattel lien is established under the Uniform

Commercial Code (UCC) The UCC is a set of guidelines adopted by 49 of

the 50 states In Texas, UCC filings are made with the Secretary

of State’s office and are generally referred to as UCC-1 filings.

The description of property secured under a UCC-1 must be reasonably specific, and current (meaning that they periodically expire and must be refiled)

Real Property

In Texas, the security interest in real property (real estate) is established through a Deed of Trust

A Deed of Trust is a three party document - the lender, borrower and trustee

The Deed of Trust is filed with the County Clerk in the county in which the real property is located, and is in effect until a release is executed by the lender and filed.

Credit Risk Management Many lenders require protective covenants and

other affirmative undertakings by the borrower as part of the loan underwriting process

A loan covenant is a condition that the borrower must comply with in order to adhere to the terms in the loan agreement

If the borrower does not act in accordance with the covenants, the loan can be considered in default and the lender has the right to demand payment (usually in full)

Why do banks add covenants to the loan agreements? Banks usually add covenants in order to

accomplish the following objectives:– Maintain loan quality– Keep adequate cash flow– Preserve equity– In a borrower with a known weakness in its

capital structure as a measure to improve this weakness

– Keep an updated picture of the borrower’s financial performance and condition

Covenants may related to:– A requirement to purchase insurance –

hazarded or crop insurance– Contracting– Hedging– Compensating checking account balances– Requirement to provide financial information

Loan Monitoring

Ongoing monitoring is a critically important component of the lending process

Collateral inspections and re-appraisals/ valuations should be performed on a regular basis by qualified personnel

A periodic review of loan documentation is important to ensure that up-to-date financial information, security agreements and UCC filings, and credit reports are maintained in the borrowers file