Why Do Lenders Sometimes Weight Collateral And Equity So Heavily?

This was a question asked by an agricultural producer panel at a recent lending school. I often joke that lenders loan money on the five “C’s” of lending: collateral, collateral, collateral, collateral and collateral. Of course, for many that is not true. Repayment capacity, character, conditions surrounding the loan and profitability are in many lenders’ toolboxes, particularly for larger commercial agricultural loans.

However, collateral and equity do play a role. They are the last line of defense for a lender in the worst-case scenario to recover monies loaned to the producer. Too little equity and collateral, and the lender and borrower can get upside down (liabilities & loan amount higher than asset value). In this case, the lender incurs losses.

A study a few years ago by Eddy LaDue at Cornell University found that equity and collateral, which represent solvency, were the number one determinant of financial success during the farm crisis years of the 1980s.

I have recently named the past 15 years of agrilending the “Golden Years.” It has been difficult to make a bad loan during this period because real estate prices have appreciated, often disguising cash flow and profitability challenges or earned net worth. Thus, collateral has played a significant role in agrilending.

Side Note

The real problem of collateral and upside down balance sheets is in the housing market. There are some cases of 125% loan-to-value in this market particularly in the red-hot areas such as California and Florida. A sniffle in the U.S. economy can bring the house of cards down. By the way, a few deep coughs are being observed in these areas already.

The Road Warrior of Agriculture

My e-mail address is: sullylab@vt.edu

Editors' note: Dave Kohl, The Corn and Soybean Digest Trends Editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups.

To see Dave Kohl's previous road warrior adventures type Dave Kohl in the Search blank at the top of the page.

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