Farm Loans: Counterparty Risks Can Blow Up Without Warning

Counterparty risk has become an increasing concern for lenders in assessing a borrower’s risk profile. Counterparty risk is defined as the risk that a party to a transaction will fail to fulfill its obligations.

Producer production and marketing contracts are an obvious example, but the concept applies to a much broader range of formal relationships. MF Global, VeraSun and Eastern Livestock have been well publicized examples, but there have also been concerns about the financial viability of several hog and poultry integrators who represent repayment risks to their contract growers. When fertilizer markets collapsed in 2008, many producers rightly worried about the security of their deposits at local retailers.

Producers can also present risks if their contracts contain quality requirements that they may fail to meet thus negating the contract or resulting in significant price discounts.

Other examples involve lenders themselves. If the size of a borrower’s loan requires the involvement of participating lenders, consider their track record of commitment. Bankers in remote cities don’t know you personally and may not share the relationship you have with a local lender or its alliance with production agriculture.

Financial problems in a participating institution, their acquisition by another lender not committed to agriculture, or their unwillingness to work with a borrower who gets into financial trouble or whose loan requires restructuring, can also represent a major risk during an economic downturn, for this reason it is better to find cash loans instead.

If the lead lender is unable to find a replacement for a participating lender who pulls out of the arrangement, it can create a house of cards where the entire borrowing relationship crumbles.

Another case which affects many products is the listed derivative markets on the major exchanges. The exchange clearinghouse is a counterparty to every sale or purchase of options or futures contracts. That eliminates the possibility that a buyer or seller won’t make good on the transaction.

The clearinghouse, in turn, protects itself by requiring market participants to meet margin requirements. However, there is no such protection in the unlisted derivatives market where forwards and swaps are arranged. The prime example was the collapse of credit defaults swaps during the 2008 financial crisis.

Farm Finances

There are also the cases of counterparties to the counterparty. If the primary contracting entity is primarily dependent on a single buyer or supplier, the failure or decision by the primary buyer or supplier to go elsewhere can also lead to financial problems. Some of these firms have also been victims of foreign buyers or suppliers being hit by changes in exchange rates, the imposition of tariffs or simply economic or political problems in their own country.

In all instances it is imperative that producers and their lenders are aware of the potential risks that each of these relationships represent. Producers need to know the financial condition of their direct counterparty as well as the domestic and global economic and geopolitical issues that may affect the relationship.

Too many producers have become victims by assuming that just because the relationship has worked in the past, it will continue to work. It is always good business to develop personal relationships, open communication and have a backup plan. The effects of increases in regulations, regulatory compliance measures and changing consumers’ tastes and preferences also need to be kept in mind. Just look at the impact that retailers and processors shifting to cage-free suppliers is having on egg producers.

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