1998 FCA Mid-Year Report - Farm Credit Administration

FARM CREDIT ADMINISTRATIONMid-Year Report1998FCA’s MissionThe Farm Credit Administration will promotea safe and sound, competitive FarmCredit System to finance rural America asauthorized by Congress.

FCA 1998Mid-Year ReportContentsPreface ................................................................................................................................................................................... 1Executive SummaryJohn Moore ..................................................................................................................................................................................................... 2Financial Performance of theFarm Credit System for the First Half of 1998 ................................................................................................................... 5Laurie Hopkins and Andrew JacobFederal Income Tax OptionsAvailable to FCSIs and Their Competitors ........................................................................................................................ 19Linda Sherman and Robert AndrosRisks Associated with the Millennial Date Change .......................................................................................................... 29Thomas Glenn and Robert AndrosEffects of a Prolonged Economic Depression in Southeast Asia on the U.S. Farm Economy ........................................ 37Paul Prentice – Farm Sector Economics, Inc.Farm Credit AdministrationFiscal Year 1999 Regulatory Performance Plan ................................................................................................................. 48Farm Credit Administration’s Loan Portfolio Management Symposium........................................................................ 50Corporate Restructuring of Farm Credit System Institutions ......................................................................................... 52Elna LuopaMajor Financial Indicators by System, Quarterly Comparison ....................................................................................... 58Major Financial Indicators by District .............................................................................................................................. 59Glossary ............................................................................................................................................................................... 60Report ManagerJohn C. Moore, Jr.Chief Economist

PrefaceFCA 1998Mid-Year Report1The Farm Credit Administration (FCA) publishesa report on the condition and performanceof the Farm Credit System (FCS orSystem) twice each year, first in the Mid-YearReport that covers the first six months andthen in the Report on the Financial Conditionand Performance of the Farm CreditSystem, which covers the calendar year.These reports focus on identifying risks fromboth within the System and outside it. Inaddition, the Mid-Year Report provides specialarticles on risk and other policy-relatedissues affecting System institutions. Thesereports also contain updates on the System’scorporate restructuring activities, FCA’sRegulatory Performance Plan, special programsand conferences, as well as tables summarizingthe latest indicators of the System’sfinancial performance. Each quarter FCAalso posts System financial indicator tablesas well as updates on the System’s corporaterestructuring efforts on its Internet Website(see address below).those of Agency analysts and do not necessarilyreflect the opinions of the FCA Boardor FCA management.System institutions are required to makecertain disclosures to stockholders, investors,and the general public. The Federal FarmCredit Banks Funding Corporation, forexample, makes such disclosures to investorsin System-wide securities on behalf of theissuing banks. Other individual System institutionsprovide similar disclosures in reportsto their respective stockholders. Thequarterly Summary Report of Condition andPerformance of the Farm Credit System, publishedby the Funding Corporation, offers adetailed set of tables showing the financialresults of the Farm Credit banks combinedwith their affiliated organizations.This 1998 Mid-Year Report on the FarmCredit System draws from a variety of sourcesincluding quarterly Farm Credit Administration(FCA or Agency) Call Reports, quarterlySystem reports, U.S. Department ofAgriculture (USDA) reports, and other Federal,state, and commercial informationsources. The figures and tables detailing theSystem’s financial performance reflect informationfrom reports filed with the Agencyby System institutions as of the close of businessSeptember 1, 1998. Unless indicatedotherwise, all projections and analyses areQuestions regarding the content of this reportmay be directed to C. Edward Harshbarger,Director, Risk Analysis Division, Office of Policyand Analysis or to John C. Moore, Jr., ChiefEconomist, 703-883-4455Single-copy subscriptions are available to thepublic free of charge. This report and recentpast reports are also available on FCA’s Website(http://www.fca.gov). Requests for subscriptionsor address changes should be mailed to:Office of Congressional and Public Affairs, FarmCredit Administration, 1501 Farm CreditDrive, McLean, VA 22101-5090; E-mail:info-line@fca.gov.

FCA 1998Mid-Year Report2Executive SummaryConditions in the agricultural economy fora wide range of commodities declined significantlyduring the first half of 1998. Infact, prices for wheat and corn have fallen solow that several billion dollars in unanticipatedloan deficiency payments will be madeto farmers in the second half of 1998. TheFarm Credit System’s (FCS’s) solid financialresults for the first half of the year do not yetreflect the stress of these deteriorating financialconditions. Rather, the June 30, 1998,results show that FCS institutions have beenable to maintain strong loan volume growth,a high quality loan portfolio, and strong earnings,and they have continued to improverisk-bearing capacity in the form of highercapital levels. The System’s financial statementswill likely begin to show the effects ofthe downturn in conditions by the end of1998 or early 1999, but at the moment, itsinstitutions are in an excellent financialposition to withstand the emerging risks.The System’s loan volume continued to growbriskly, with gross outstanding loans at $65.6billion on June 30, 1998—an increase of 4.8percent from the previous year. The largestincreases came in short- and intermediatetermloans, which jumped 11.6 percent, whilereal estate loans increased by 4.6 percent.This growth resulted from continued stronggains in land prices, a trend that may soonreverse if, as expected, farm income declinessubstantially from 1996 and 1997 levels. Theupsurge in short- and intermediate-termloans may be partly attributable to farmers’choosing to store crops and wait for higherprices while borrowing more for currentoperating expenses. Other factors influencingloan growth include the System’s enhancedmarketing efforts, more efficientcredit-delivery systems, and competitive pricingprograms. As of the end of the firstquarter of 1998, however, the increase inagricultural loans at commercial banks wasgreater than that in the System. In fact, as ofthe end of the first quarter commercial banks’annual growth rates for agricultural loanshave outpaced the System’s growth (in loansto farmers) four quarters in a row. Loans tocooperatives, meanwhile, fell slightly over thelast 12-month period and loans made inconnection with international transactionscontinued a trend of paydowns of loans tosome countries.The report contains a special section linkingconditions in the agricultural economy tocommodity concentrations (as of June 30,1998) in the Farm Credit System’s loan portfolios.The largest such concentrations inSystem-wide farm lending portfolios are corn(10.3 percent), dairy (10.2 percent), beefcattle (8.3 percent), wheat (4.5 percent), hogs(4.3 percent), cotton (3.4 percent), and soybeans(2.7 percent). Except for dairy andcotton, these commodities are experiencingserious price declines. As one would expect,a more detailed, district-by-district reviewturned up much higher concentrations ofthese stressed commodities in certain districts.However, the credit quality of the System’sportfolios continued to improve or remainstable as acceptable loans reached 89.2 percentof loan volume. Other loan-qualityindicators also showed consistent upwardtrends: nonperforming assets declined to 1.3percent of total loans; non-accrual loans fellto one percent of total loans, and delinquenciesremained stable and low. The effects ofthe recent deterioration in economic conditionswould not be expected to show up incredit quality indicators until later.System capital increased by $1.1 billion to$12.2 billion or 15.1 percent of assets, upfrom 14.5 percent a year earlier. Surplus, thetype of capital that counts toward two relativelynew standards, reached $8.8 billion,while “restricted capital” (the amount in theFarm Credit System Insurance Fund) increasedto $1.4 billion.The System’s net income for the first sixmonths of 1998 was $666 million. The $59million gain from the year before resulted

FCA 1998Mid-Year Report3from the increased loan volume and highercapital levels. In addition, while various economicand financial developments have increasedspreads between System securitiesand those of the U.S. Treasury, funding costshave remained stable. The System’s annualizedreturn on average assets thus increasedslightly, to 1.68 percent.This Mid-Year Report also offers several otherpertinent analyses. One article looks at thevarious tax structures available to Systeminstitutions and their commercial bank counterpartsand compares the tax savings availableto each. For example, although cooperativeshave the same rights and responsibilitiesas other businesses, including theresponsibility to pay taxes, their unique structureand purpose requires a separate sectionin the Internal Revenue (IR) Code, SubchapterT, which sets forth the qualifications andcriteria for the taxation of cooperatives,including several options for the distributionof surplus or earnings. The IR Code providesthe option for taxation on the earningsof cooperatives, at either the corporate or theindividual level—whichever is most advantageousto the cooperative and its members.This requirement differs from those for mostinvestor-owned general businesses, whichpay taxes at both the corporate level andagain when dividends are distributed at theindividual level. Half of the System’s taxableinstitutions now file as Subchapter Tcooperatives.Recent legislation gives many commercialbanks and thrifts the opportunity to reorganizeas Subchapter S corporations, whichenjoy tax benefits similar to those accordedSubchapter T cooperatives. Since there aresubstantial financial benefits associated withsingle taxation, more than 10 percent of thenation’s banks, many located in rural andagricultural sections of the country, have convertedto S corporations in the last 18months. Many more are expected to convertin the near future.An article on the year 2000 (Y2K) computerproblem discusses the serious challenge facingthe financial services sector, includingFarm Credit System institutions. In sum, itlooks as though it will be impossible for anyfinancial services firm to entirely insulate itselffrom the economic repercussions of themillennial date change. At a minimum, someadverse economic effects are likely to be feltwithin the financial services sector, includingthe FCS and its customers. Every financialinstitution faces a series of risks associatedwith the millennial date change in itscomputer systems; embedded systems; supplier,client, and servicer interfaces; customerrelations and related ripple effects; infrastructure,and government services. Failure toaddress each area of risk successfully canincrease the potential for legal liability. FCAhas provided and will continue to providetimely and comprehensive guidance to Systeminstitutions at both the general and individualinstitution levels. Institutions maybe able to mitigate their liability exposure ifthey follow FCA’s Y2K guidance and candocument that they did so.Another article focuses on the importanceof agricultural exports and the effects of thedecline in Asian economies on Americanagriculture. Over the last three years Asianmarkets have absorbed about 48 percent ofU.S. export value. A quantitative modelshows how alternative scenarios for Asiangrowth might affect the 1998-2002 forecastfor farm income, real estate values, and debtfor the Nation and for each Farm Credit district.Significantly, in the Baseline forecastthe strong mid-1990s growth in real estateprices is forecast to reverse in 1999. In fact,prices are predicted to decline slightly in 1999and remain weak through the forecast period—moreso in the Asian Depression scenario.Fortunately, unless the Asian Depressionscenario comes to full fruition, the worststresses will be localized and short-lived comparedwith those of the 1980’s.

FCA 1998Mid-Year Report4This report also contains the Agency’s RegulatoryPerformance Plan for Fiscal Year 1999.The plan provides a brief description of eachregulatory project intended for developmentin the upcoming fiscal year.The FCA will sponsor a symposium in Decemberto highlight some of the more criticaland timely aspects of loan portfolio management.The symposium will provide aforum for discussing risk-related managementissues associated with agricultural lending.Key topics such as management informationsystems, portfolio stress testing, andenvironmental risk evaluation will be discussed.The symposium is structured forSystem personnel including chief executiveofficers, chief credit officers, and others involvedin the credit function.This Mid-Year Report provides an overviewof trends in the System’s corporate restructuringactivities. As of October 1, 1998, therewere 201 System banks and associations -13fewer than existed a year earlier. The mostsignificant decline was in the number ofFederal Land Bank Associations (FLBAs),which dwindled by nine to 40 as a result ofmergers in the Texas District and the formationin the Wichita District of direct lenderFederal Land Credit Associations (FLCAs).FLBAs affiliated with the Farm Credit Bankof Texas also are expected to begin the transitionto FLCAs by mid-1999, assumingshareholders approve the Bank’s proposedplan to transfer direct lending authority.There have been no mergers among the eightFarm Credit banks in the System since April1995.On July 14, 1998, the FCA Board adopted aphilosophy stating its belief that “unrestrictedintra-System competition is beneficial for thecustomer and the long-term relevancy of theFarm Credit System.”September 25, 1998

Financial Performance of the Farm CreditSystem for the First Half of 1998FCA 1998Mid-Year Report4Laurie Hopkins and Andrew JacobOverview: Farm Credit SystemPosts Solid Financial Results, WhileStress in the Agricultural EconomyPoints to Risks on the HorizonThe Farm Credit System’s solid financial resultsfor the first half of 1998 do not reflectthe stress associated with increasingly difficultagricultural economic conditions. Withcontinued adversity, however, the quality ofthe Farm Credit System loan portfolio maydecline, which in turn may reduce the strongfinancial performance it has realized duringmost of the 1990’s. However, in anticipationof the downturn in agriculture, the Systemhas built its risk bearing capacity to withstandthis adversity.Agricultural Economy: IncreasinglyDifficult Conditions in Mid-1998Despite an overall robust U.S. economy anda period of strong net farm income throughoutmost of the 1990’s, concerns have developedabout recently falling commodityprices, declining net farm income, and difficultweather conditions. Corn, wheat, soybeans,hogs, and cattle are the most seriouslystressed commodities because of the downturnin current economic conditions. Mostproducers entered 1998 in a fairly strong financialposition that will serve as a crucialcushion for many of them. In 1997, farmersand ranchers experienced a turnaround inthe cattle industry and near record crop harvests,which brought widespread profits.Debt loads have not risen to burdensomelevels overall partly because many farmershave opted to pay down loans rather thanincur increased debt. A recent U.S. Departmentof Agriculture (USDA) study showedthat the number of highly leveraged farmswith debt/asset ratios above 70 percent wasabout 4 percent at the end of 1997. This isconsistent with levels observed during theprevious 5 years but well below the levelobserved during the mid-1980’s, when 10percent of the farmers were in this category.However, farmers who ended 1997 withouta financial cushion because of weather orother problems are likely to experience loanrepayment problems in 1998. The main issuesfacing the agricultural economy are discussedbelow.Adverse weather conditions will lead topoor crop yields or crop failure inseveral states.The Southern drought, extreme heat anddrought in Texas, spring floods and cropdisease in the Northwestern Plains, and unseasonablywet and cool weather in Californiahave altered expected crop productionin these areas significantly. For example,difficult weather conditions in Texas andOklahoma will cut this year’s domestic cottoncrop by 25 percent, lowering overall outputand raising prices. In the Northern Plainsthe poor growing conditions (spring flooding)and diminished yields of 1997 havespilled over into 1998 and left producers withmounting financial problems. Conversely,other areas of the United States have experiencedfavorable weather conditions, andoverall harvests of corn, soybeans, and wheatwill be at or very near record levels, which islikely to further depress prices.Commodity prices are falling underthe weight of near record harvests andfaltering demand.Increased worldwide supply paired withweaker export demand has depressed commodityprices significantly for U.S. farmers.Prices were quite favorable in 1995, 1996, andmuch of 1997, and stocks were low. Chart 1depicts the relationship between favorablecommodity prices and low stock levels forcorn, which is the same trend seen for wheatand soybeans. The favorable prices werestrong signals to increase production. Expansionalso was fueled in part by confidencethat exports to Asian markets would continueto grow. However, an increase in foreigncompetition from Argentina, Brazil, andAustralia and solid U.S. yields have contrib-This article reviews the increasingly difficultconditions in the agricultural economy.In addition, components of the System’sfinancial condition are assessed with emphasison commodity concentrations in eachFarm Credit System district.

FCA 1998Mid-Year Report6Chart 1Corn Stocks/Use Ratio and Priceas of 3/1/98Source: Agricultural Outlook, Economic Research Service, U.S. Department of Agricultureuted to the rapid decline in commodityprices. Although China is also an importantforeign competitor, poor weather has recentlyaffected its agricultural production. Depressedprices have reduced the value of U.S.exports even though the volume of commodityand red meat exports was up fromOctober 1997 to June 1998.For wheat, corn, soybean, cattle, and hogproducers, prices are substantially lower thanthey were during 1997. Unfortunately, USDAexpects season average prices for 1998–99 forthese commodities to be even lower than forthe 1997–98 season. Farmers are preparingto bring in the largest soybean crop, the secondlargest corn crop, and among the largestwheat crops ever, which portends continuedprice weakness for these grains. Meat productionhas also increased so that hog priceshave been low all year long and cattle priceshave begun to weaken recently. Conversely,strong demand for certain dairy products,such as butter, cheese, and milk fat, has supportedmilk prices, although the patternshave been uneven due to erratic milk supplies.Net farm income for 1998 is forecast todecline by 15.8 percent.As of late September, the USDA had loweredits forecast of net farm income largely becauseof declining commodity prices. Asshown in Chart 2, the USDA reduced the1998 forecast by $ 7.9 billion from 1997 and$11.5 billion from the 1996 record. Yet it isup $5.9 billion from 1995 and is 7.3 percentbelow the average for the 1990’s. Direct governmentpayments are forecast by USDA tobe $7.4 billion for 1998, slightly lower than1997 and the average for the 1990’s. However,this forecast will be reversed upwardbecause government loan deficiency paymentswill increase substantially as commodityprices fall. Throughout the 1990’s directgovernment payments have averaged 19.2percent of net farm income, assisting producersduring the particularly difficult yearsof 1991, 1995, and now 1998.

FCA 1998Mid-Year Report7Chart 2Total Net Farm Income, 1990-1998as of September 24, 1998In BillionsP= Preliminary A=Average of time period F=ForecastSource: Derived from Economic Research Service data, U.S. Department of AgricultureGovernment assistance will helpalleviate some financial hardship fortroubled farmers.The Federal government has launched anassistance package to mitigate the weatherrelatedstresses affecting many farmers. Immediateinitiatives include a lifting of sanctionsagainst foreign grain sales and a $250million wheat purchase funded by the CommodityCredit Corporation that aims to raiseprices and fulfill a humanitarian need in theform of food relief overseas. Other solutionsinvolve moving $5.5 billion in crop supportpayments from 1999 to late fall 1998, andabout a half billion dollars in low interest rateloans to alleviate financial pressures of someof the hardest hit farmers. In addition, commodityprices have fallen below the USDAloan price support level, especially for wheatand corn producers. Depending on how longthis condition exists, several billion dollarsin loan deficiency payments may be made tofarmers by the USDA in the coming months.Farm Credit System FinancialPerformance: Ability to WithstandRisks on the HorizonThe Farm Credit System’s financial performanceduring the first half of 1998 was soliddespite the challenging aspects of the agriculturaleconomy. The Farm Credit Systemhas been able to maintain loan volumegrowth and a high quality loan portfolio,which has sustained strong earnings. Earningshave helped build the System’s capitalposition to healthy levels, thereby improvingrisk-bearing ability. However, commodityconcentrations represent a continued sourceof risk.Loan volume has grown significantly,particularly for both short- andintermediate-term loans.The Farm Credit System’s loan portfolio (includingcooperative lending) grew 4.8 percentfor the period June 30, 1997, to June 30,

FCA 1998Mid-Year Report8Chart 3FCS Loan Portfolio: Percent Change fromSecond Quarter of Previous Year as of June 30, 1998Source: Derived from FCA Report to Investors1. A District is a Farm Credit System bank (i.e., Farm Credit Bank orAgricultural Credit Bank) combined with its affiliated associationswith the exception of St. Paul Bank for Cooperatives. Districts arereferenced throughout by Farm Credit System bank name as follows:AgAmerica, AgFirst, AgriBank, Texas, Wichita, Western, andCoBank.1998. During this period, total loansincreased from $62.6 billion to $65.6 billion.The $3 billion increase was concentrated inlong-term real estate and short- and intermediate-termloans, while domestic loans tocooperatives and export financing fell. Chart3 indicates that the increase in loan volumewas led by short- and intermediate-termloans, which jumped 11.6 percent, growingfrom $16 to $17.8 billion. Long-term realestate loans increased 4.6 percent, from $30to $31.4 billion. The continued upsurge infarmland values contributed to the growthin long-term real estate loans collateralizedby farmland, including those used for purposesother than the purchase of land. However,farmland values may be stalling in someregions because net farm income is expectedto decline. Diminishing direct governmentpayments under the 1996 Freedom to FarmAct will also limit upward pressure on landvalues. If farmland values begin to level offor even fall, lenders will likely reduce realestate lending in the near future. The rise inshort- and intermediate-term loans is consistentwith the significant growth shown inthis area during the same periods in 1995and 1996. The recent upsurge of short-termloans may be partly attributable to farmerschoosing to store crops and borrow morefor operating expenses. By District, non-realestateloan growth was particularly robust inthe AgAmerica District, up 20.4 percent,while long-term real estate lending showedsignificant growth of 19.3 percent in theWestern District. 1Domestic loans to cooperatives fell from$14.4 billion to $14.3 billion for the 12-monthperiod ending June 30, 1998. This area ledthe Farm Credit System for increases in loanvolume during the same periods of 1995 and1996, but declined in 1997 and in 1998.Cooperatives have required fewer funds becauseof low commodity prices, weak demand,and increased storage of crops byproducers. Loans made in connection withinternational transactions declined 8.6 percent,from $2.3 billion to $2.1 billion, becauseof on-going loan pay-downs, continuing atrend that began in 1995.Long-term agricultural real estate loans arethe predominant portion of the Farm CreditBanks and associations’ loan portfolios (seeChart 4). These loans are collateralized byreal estate and are used to finance farmland,farm buildings, and other longer-term capi-

FCA 1998Mid-Year Report9tal needs. Non-real-estate loans provideshort-term working capital needs for cropproduction and intermediate-term loans forequipment and other similar capital goods.These two loan types accounted for 93.1percent of loans made by Farm Credit Banksand associations as of mid-year 1998, littlechanged from the average of 93.0 percentduring 1994–1997.Commercial bank agricultural loangrowth outpaced the Farm CreditSystem’s loan growth.Over the past decade, commercial banks havecompeted effectively with the Farm CreditSystem, capturing an increasing market shareof agricultural loans. Recent data show thatgrowth in commercial banks’ agriculturalloans has outpaced Farm Credit Systemgrowth for the last four quarters, as shownin Chart 5. From March 31, 1997, to March31, 1998, commercial bank farm loans increased9.8 percent, the highest percentagegrowth rate of the 1990’s. 2 At March 31, 1998,commercial bank farmland and agriculturalproduction loans outstanding reached $69.9billion. Much of the growth has come fromtraditional commercial agricultural banks,which showed an 11.6 percent increase incombined farmland and agricultural productionlending for the past year. As of March 31,1998, there were 2,327 commercial agriculturalbanks. 3Loan volume at Farm Credit Banks andassociations grew.Loan growth varied widely by District, withthe greatest percentage growth observed inAgriBank and AgAmerica Districts (seeChart 6). From June 30, 1997, to June 30,1998, loans outstanding in these two Districtsincreased about 10.0 percent compared to amore moderate 3.5 percent loan growth inthe Wichita District. The CoBank District(which includes lending by affiliated associationsin the Northeast and to agriculturalcooperatives) experienced a slight decline of0.7 percent due to less borrowing by domesticcooperatives. The St. Paul Bank for Cooperatives(St. Paul BC) had a significantdecline of 12.4 percent in loan volume. Manydirect lender associations posted solid growthChart 4Distribution of Loans(excluding cooperatives and international)as of June 30, 1998Source: Loan Account Reporting System (LARS)Chart 5Commercial Banks Agricultural Loan Growth Recently Surpassed FarmCredit System Loan Growth (excluding cooperatives and international)Source: Derived from Sheshunoff Bank Search and LARS Data, which excludes rural home, farm related business,processing, and marketing, aquatic, and other.2. First quarter 1998 data is used in this discussion because thecommercial bank Call Report data is derived from Sheshunoff InformationServices, which does not release its second quarter1998 data until late September.3. As defined by the Federal Deposit Insurance Corporation (FDIC), acommercial agricultural bank is a bank with total agricultural loansin excess of 25 percent of its total loan portfolio.

FCA 1998Mid-Year Report10Chart 6Loans Outstanding Grew in Most Districts 2nd Quarter 1997 Comparedwith 2nd Quarter 1998In BillionsChart 7Farm Credit System: Sampling ofMajor Commodity Concentrationsas of June 30, 1998Source: Summary Report of Condition and Performance of the Farm Credit SystemTotal FCS Loans: $48.6 billion4. A loan is assigned to a specific commodity category if 50 percentor more of the borrower’s loan value is concentrated in a givencommodity. The charts represent commodity concentrations accordingto three qualifications. First, the top three commoditiesby total loan concentration were selected for each District. Second,seven major commodity categories (corn, wheat, soybeans,cattle, dairy farms, hogs, and cotton) were selected and highlightedif the category represented 2.5 percent or more of loan volume.Last, the ‘other*’ category captures all commodities that did notmeet the first two requirements, and all concentrations that represent8 percent or less of loan volume. Concentration data wasderived from the Loan Account Reporting System (LARS) and doesnot include cooperative lending. Underlying loan diversity isgreater than the data suggests because each borrower is categorizedby only the major commodity produced. Typically, farmersand ranchers are diversified through the production of more thanone commodity. Nevertheless, the LARS data is a mechanism foridentifying regions with a high degree of concentration in stressedcommodities.from June 30, 1997, to June 30, 1998. Duringthis period, total loans outstanding grew bymore than 10 percent at 46 associations, and15 associations experienced a growth rate inexcess of 20 percent.The Farm Credit System has significantconcentration in stressed commodities.4As a single industry lender, the Farm CreditSystem has significant exposure to thestressed U.S. agricultural economy. Loanportfolio concentration in certain stressedcommodities, especially wheat, corn, soybeans,hogs, and cattle, is an indication ofwhere difficulties may appear. Evidence ofproblems may appear in the form of increaseddelinquencies after the marketingyear has passed. As a group, all Farm CreditBanks and associations have the highestcommodity concentrations in corn loans at10.3 percent, dairy loans at 10.2 percent, andbeef cattle and cattle feedlot loans at a combined11.4 percent (see Chart 7). However,individual Districts have different concentrationexposures to stressed commodities andrelated risk.The Texas District may experience an increasein loan problems because of its concentrationin cattle loans, representing 33.8percent of the loan portfolio (see Chart 8).Despite this concentration, the prevalence ofpart-time cattle producers in the area maymitigate overall difficulties. Cotton loans,which constitute 14.4 percent of the portfolio,are vulnerable due to the extreme droughtthat has ravaged the area’s production.Chart 8Texas Districtas of June 30, 1998Gross Loans: $4.1 billion

FCA 1998Mid-Year Report11Chart 9Western Districtas of June 30, 1998Gross Loans: $5.5 billionChart 11CoBank Districtas of June 30, 1998Gross Loans: $1.9 billionThe Western District’s loan portfolio showsconcentrations in grape loans at 16.1 percent,dairy farming at 14.9 percent, and treenuts at 8.1 percent (see Chart 9). Hence, theperformance of the Western District’s overallportfolio is less likely to be affected significantlyby weaknesses in the agriculturaleconomy given its loan diversity and lack ofconcentration in any of the major stressedcommodities. However, reduced export demandfor fruits and vegetables and recentadverse weather may cause difficulties formany producers.In the Wichita District, stressed commodities(cattle, wheat, corn, and soybeans) constitute59.6 percent of the loan portfolio. Thefinancial health of the producers of thesecommodities is especially vulnerable andmay cause future deterioration in the qualityof the loan portfolios in the Wichita District(see Chart 10).CoBank’s loans to producers in the Northeasthave a heavy concentration in dairyfarms (39.1 percent) along with lesser concentrationsin ornamental floriculture at 11.2percent and berry crops at 5.3 percent (seeChart 11). Dairy producers in this districtmay be bolstered by the decline in feed pricesand continued strong demand for dairyproducts.Loan concentrations in the AgFirst Districtare evenly distributed among producers ofbroiler/fryers, beef cattle, and dairy at approximately9 percent each. As a result, theloan portfolio shows substantial diversity andlack of concentration in troubled commodities,which serve to mitigate negative economicimpacts on the area (see Chart 12).The AgriBank District, which straddles theNorthern Plains and the Corn Belt, mayencounter stress because of its 33.6 percentconcentration in corn, wheat, cash grain, andsoybean loans, and another 6.8 percent inChart 10Wichita Districtas of June 30, 1998Gross Loans: $3.9 billionChart 12AgFirst Districtas of June 30, 1998Gross Loans: $8.8 billion

FCA 1998Mid-Year Report12Chart 13AgriBank Districtas of June 30, 1998Gross Loans: $16.9 billion5. All credit classification ratios include accrued interest receivable.Loans classified OAEM exhibit potential weaknesses and adversefinancial and operational trends that have yet to impact repayment.Compared with the acceptable and OAEM classifications,adversely classified loans are loans with greater repayment riskand where collection in full is a concern. Adversely classifiedloans represent the sum of loans classified Substandard, Doubtful,and Loss.hog loans (see Chart 13). Prices for thesecommodities are forecast to remain weak.However, dairy loans represent 12 percent oftotal loan volume, and these loans will likelybenefit from a stronger dairy market.The AgAmerica District has its highest loanportfolio concentration in corn at 14.2 percent,beef cattle at 10.0 percent, and wheat at8.1 percent, all of which face falling prices(see Chart 14). However, AgAmerica showsloan portfolio diversity and overall low concentrations,which should dampen the effectsof declining prices in certain commodities.Asset quality currently remains at ahigh level.The Farm Credit System’s loan portfolio remainsin solid condition as measured bycredit classifications in relation to risk fundsand nonperforming loan statistics. The highquality of the loan portfolio has been responsiblefor the excellent financial performanceby Farm Credit System institutions. Furthermore,strong financial performance has builtrisk-bearing ability through capital growthand strong earnings. As a result, the FarmCredit System is in a good position to withstandthe emerging risks from a deterioratingagricultural economy. While these risksare not currently apparent when viewingearly warning indicators such as delinquencies,credit classifications, or provision forloan losses, continued poor weather and lowcommodity prices may lead to some deteriorationin loan portfolio quality by the endof 1998.Credit quality slightly improved.As shown in Chart 15, credit quality for FarmCredit System banks and associations hasimproved slightly over the past several years.Acceptable loans have reached 89.2 percentof total loan volume 5 while the level of OtherAssets Especially Mentioned (OAEM) andadversely classified loans have remained relativelysteady at approximately 6 and 5 per-Chart 14AgAmerica Districtas of June 30, 1998Gross Loans: $7.5 billion

FCA 1998Mid-Year Report13Chart 15Combined System Banks and Associations Quality Improved Slightlyas of June 30, 1998Source: Summary Report of Condition and Performance of the FCScent of the portfolio, respectively. All Districtsmaintained asset quality at high levels,with most reporting some improvements. 6While still at a high level, AgriBank’s assetquality fell slightly as the level of loans classifiedacceptable dropped to 88.2 percent oftotal loans at June 30, 1998, compared with91.9 percent a year earlier. The AgriBankDistrict experienced a corresponding increasein loans classified OAEM, which indicatespotential future weaknesses and adversefinancial trends for borrowers. These weaknessesare partly attributable to weather andother related problems with crop productionexperienced over the past few years. Althoughasset quality was strong overall, theSt. Paul BC exhibited weaker asset qualityrelative to other Farm Credit System banks.Asset quality of direct lender associationsremained relatively stable from June 30, 1997,to June 30, 1998. The number of direct lenderassociations with adverse assets in excess of10 percent of total loan volume and otherproperty owned (OPO) dropped from 15 to10 associations. 7 However, the number ofdirect lender associations with adverse assetsto total loans ranging from 5 to 10 percentincreased by 9, to 50 associations. Most ofthe increase was with several associations thatmoved to just above the 5 percent level. AtJune 30, 1998, the Farm Credit System had147 direct lender associations.Capital and allowance for loan lossespositions were sufficient comparedwith portfolio risk.On a combined basis, Farm Credit Systembanks and associations have sufficient capitaland allowance for loan losses in relationto the level of adverse assets. Adverse assetsrepresented 25.2 percent of capital and allowancefor loan losses at June 30, 1998, comparedwith 26.7 percent at June 30, 1997.As of June 30, 1998, only 3 associations hadadverse assets to risk funds (permanent capitaland allowance for loan losses) exceeding50 percent, a drop from 11 associations a yearearlier. None were in excess of 66 percent.Adverse assets to risk funds greater than 50percent is an indicator of greater risk levelsrelative to risk-bearing ability. However, 39associations had a ratio between 30 and 50percent, compared with 27 associations a yearago.6. Districts were defined in footnote 1. St. Paul BC is not considereda District because it has no affiliated associations.7. Adverse assets are adversely classified loans and OPO.8. Nonperforming assets are nonaccrual loans, accruing restructuredloans, accruing loans 90 days or more past due, and OPO.

FCA 1998Mid-Year Report14Chart 16Trends in Nonperforming Assetsas of June 30, 1998Source: Report to Investors, Quarterly Information StatementNonperforming loans have declined asa percentage of total loans.Along with a high level of asset quality, theFarm Credit System’s nonperforming assetsposition has improved. 8 Nonperforming assetswere 1.3 percent of total loans at June 30,1998, compared with 2 percent a year earlier(see Chart 16). The Farm Credit System’slevel of nonperforming assets is comparableto the level for commercial agricultural banks,which was 1.2 percent at March 31, 1998. Thelevel of nonperforming assets improved significantlybecause of the resolution of severallarge loans to domestic cooperatives.Capital and the allowance were sufficientrelative to the level of nonperforming assets.At June 30, 1998, nonperforming assets were6.2 percent of capital and allowance for loanlosses, a significant decline from 9.9 percentat June 30, 1997.The improvement in nonperforming assetscame mainly from continued reductions innonaccrual loans. At June 30, 1998, the FarmCredit System’s level of nonaccrual loans represented1.0 percent of total loans. By District,the level of nonaccrual loans to totalloans ranged from a low of 0.8 percent to ahigh of 2.1 percent compared with a rangeof 1.0 to 5.4 percent a year earlier. At theassociation level, 10 associations reportednonaccrual loans in excess of 1.75 percent ofgross loans compared with 27 associationsat June 30, 1997. Risk funds coverage ofnonaccrual loans was sufficient consideringthe ratio of nonaccrual loans to risk funds of13 percent at June 30, 1997, and 11 percent atJune 30, 1998.The level of loans 90 or more days delinquentand still accruing interest has beenstable and has remained low. The level hasremained at around 0.1 percent for the FarmCredit System on a combined basis and forthe individual Districts. Similarly, accrualloans 30 or less days delinquent have remainedbelow 1.0 percent for the past severalyears.Adequate allowance for loan lossesbolsters the System’s risk bearingability.The level of the allowance is consistent withthe Farm Credit System’s loan volume growthand expected risks emanating from the loanportfolio. However, if commodity prices remainlow and adverse weather conditionscontinue, asset quality may deteriorate andthe Farm Credit System may have to increasethe allowance. Allowance for loan losses was

FCA 1998Mid-Year Report15Chart 17Risk Bearing Ability ImprovedIn BillionsSource: Report to Investors, Quarterly Information Statement$1.9 billion at the end of the second quarterand represented 2.8 percent of total loans.The allowance has remained around 2.8 percentover the past 4 years, higher than the2.0 percent for commercial agriculturalbanks. The Farm Credit System’s higher allowanceis appropriate because commercialagricultural banks are able to diversify theirloan portfolios in economic sectors otherthan agriculture. Allowance accounts aremaintained through the provision for loanlosses on the income statement. The provisionexpense for the first 6 months that endedJune 30, 1998, was $32 million, down significantlyfrom $67 million for the 6-monthperiod that ended June 30, 1997, and $57million for the 6-month period that endedJune 30, 1996. The trend in the provision forloan losses indicates that the quality of theloan portfolio does not require any buildupin the allowance.Investments increase to meet liquidityand interest rate risk needsEach Farm Credit System bank maintains aninvestment portfolio primarily for liquiditypurposes. The investment portfolio consistsof highly rated, guaranteed, mortgage-backedsecurities, asset-backed securities, corporatedebt, and short-term securities such as commercialpaper, negotiable certificates of deposit,and Federal Funds sold. On June 30,1998, the investment securities totaled $12.7billion and represented 16.2 percent of totalassets. This compares with investments totaling$11.8 billion and 15.5 percent of totalassets on June 30, 1997. The growth in investmentsis attributable to increased liquidityneeds due to discount note funding andadditional use of investments to help manageinterest rate risk exposures. By regulation,the size of each Farm Credit Systembank investment portfolio is limited to 30percent of gross loans.Capital growth builds the Farm CreditSystem’s risk-bearing capacity.Farm Credit System capital totaled $12.2billion on June 30, 1998, compared with $11.1billion a year earlier. The Farm Credit Systemhas significant capital levels to assist inguarding against risks emanating from thestressed agricultural economy. For the 12-month period ending June 30, 1998, total

FCA 1998Mid-Year Report16Chart 18Spreads Tighten but Net Margin Stays Strong due to Higher Capital LevelsRates (%)Source: Report to Investors, Quarterly Information Statement9. Assets in the Insurance Fund and the capital related thereto aredesignated as restricted assets and restricted capital, respectively.The classification of the Insurance Fund as restricted capital isbased on the statutory requirement for the amounts in the InsuranceFund, which is under the control of the Farm Credit SystemInsurance Corporation, and is to be used solely for the purposesspecified in the Farm Credit Act of 1971, as amended, all of whichbenefit System institutions directly or indirectly.10. For the Farm Credit System, the major components of capital aresurplus, capital and participation certificates, restricted capital,and accumulated other comprehensive income.11. A basis point is 1/100 of 1 percent.capital increased by $1.1 billion due to continuedstrong earnings performance. Despitean increase in assets, capital has increased asa percentage of assets to 15.1 percent, up from14.5 percent at June 30, 1997 (see Chart 17).Excluding restricted capital, the ratio of capitalto assets was 13.7 percent at June 30, 1998,compared with 13.1 percent at June 30, 1997. 9At June 30, 1998, total capital included $8.8billion in surplus, up from $7.9 billion a yearearlier. 10 Similarly, the level of capital stockand participation certificates was $1.9 billion,virtually unchanged from a year earlier, whilerestricted capital increased to $1.4 billionfrom $1.2 billion a year earlier. Accumulatedother comprehensive income, associated primarilywith unrealized gains and losses oninvestments, was $38 million compared with$15 million a year earlier.The FCA requires each institution to maintaina minimum of 7 percent permanentcapital to risk-adjusted assets; 7 percent totalsurplus to risk-adjusted assets; and 3.5 percentcore surplus to risk-adjusted assets ratio.As of June 30, 1998, two institutions werenot in compliance with the Agency’s coresurplus requirement. However, these institutionsare operating under Agency-approvedcapital restoration plans, which putsthem in technical compliance with the capitalregulations.Earnings remain strong despite atightening in interest spreads.For the first 6 months of 1998, the FarmCredit System’s net income was $666 million,up $59 million from the same periodlast year. The gain was attributable to increasedloan volume, higher capital levels,and stable funding costs. Interest-free funds(capital invested in interest earning assets)increased by $1 billion due to earnings retention(see Chart 18). The increase in interestfree funds helped offset the 20-basispoint-reductionin the net interest spread(rate on earning assets minus the rate oninterest bearing liabilities) experienced sinceJune 30, 1996. 11 As a result, the net interestmargin remained close to 3 percent over thepast 4 years. The Farm Credit System posteda healthy 2.92 percent net interest margin atJune 30, 1998, compared to 2.90 percent 1

FCA 1998Mid-Year Report17Chart 19Mid-Year Profitability Remains StrongReturn on Average Assets (%)Return on Average Equity (%)Source: Derived from Report to Investors, Quarterly Information Statementyear earlier and 3 percent 2 years earlier. Inthe future, profitability may come under somepressure as provisions are made to the allowanceto reflect agricultural economic weaknesses.Profits remain strong.Since 1995, the Farm Credit System has consistentlyposted an annualized return on averageassets (ROAA) in excess of 1.6 percentfor the first 6 months of each year. At June30, 1998, the annualized ROAA was 1.68percent compared with 1.61 percent for June30, 1997, and 1.81 percent for June 30, 1996(see Chart 19). Similarly, the annualized returnon average equity (including restrictedcapital) was 11.25 percent at June 30, 1998,compared with 11.19 percent for June 30,1997.Uncertainty exists with regard to interest ratestability given the Asian and Russian economiccrisis. Currently the Federal Reservehas chosen to maintain interest rates whichhas stabilized the Farm Credit System’s costof debt. However, the spreads between FarmCredit System debt securities and U.S. Treasurysecurities have been widening due toreduced Treasury issuance during a periodof strong investor demand. U.S. Treasuryissuance is down due to the budget surplusresulting from strong U.S. economic performance.Investor demand has increased fromuncertainties associated with the Asian economiccrisis and the recent Russian currencydevaluation and debt default. This global uncertaintyhas generated a flight-to-quality toU.S. Treasury securities and pushed rates onsuch securities to very low levels. Similarly,the swap debt curve has widened comparedto U.S. Treasury securities, which has putfurther pressure on Farm Credit Systemspreads, particularly for intermediate- andlong-term securities. For example, spreadson 10-year, fixed-rate securities had widenedto 63 basis points by September 1, 1998, comparedwith 29 basis points at the end of January1998.

FCA 1998Mid-Year Report

Federal Income Tax Options Available toFCSIs and Their CompetitorsFCA 1998Mid-Year Report19Linda Sherman and Robert AndrosBackgroundTaxes are an inescapable and necessary costof doing business in this country. OliverWendell Holmes once said, “Taxes are theprice we pay for a civilized society.” Most ofus would agree that the taxes we pay providea great environment in which to live. Mostof us would agree that we are willing to payour fair share of the cost of maintaining oursociety. But most of us would also agree thatwe do not want to pay more than our fairshare. Determining our fair share can bedifficult and costly process, and the cooperativebanking system presents an especiallycomplicated picture.Organizational structure affects tax obligations.According to the U.S. Department ofCommerce, American businesses generallytake one of six common organizationalforms: sole proprietorships, partnerships,limited liability companies, cooperatives,Subchapter S corporations, and general business(or Chapter C) corporations. Of these,only Chapter C corporations are required topay income taxes at both the corporate andthe individual-owner level. More and moreAmerican businesses are discovering ways toavoid double taxation. In 1997, only 1 of 10businesses in the United States operated as aC corporation.FCSIs, as cooperatives, fall into three tax filingcategories: They may be tax-exempt; fileas C corporations under Chapter 1, SubchapterA, of the Internal Revenue Code (IRCode); or file as cooperatives under SubchapterT of the IR Code. Out of 203 FCS associations,approximately 32 percent pay corporatetaxes as C corporation filers. The restare either tax-exempt (38 percent) or takeadvantage of Subchapter T rules (30 percent)to pass earnings through to shareholders aspatronage dividends and forgo paying corporatetaxes on that income. Table 1 showsthe breakdown of FCSI filing status as ofJanuary 1, 1998.The Farm Credit Act has always granted taxexemptstatus for income generated by mortgagelending by Farm Credit Banks (FCBs),Federal Land Bank Associations (FLBAs),and Federal Land Credit Associations(FLCAs). In contrast, income generated fromproduction and cooperative lending by ProductionCredit Associations (PCAs) andBanks for Cooperatives (BCs) is not taxexempt.This distinction was simple whenthere were only a few types of System institutionsand their lending activities wereclearly distinguished as either short-term(agricultural operations), long-term (agriculturalmortgages), or cooperative (cooperativeloans) lending operations. After 1987,the structure of System institutions began tochange. Institutions merged in order toachieve operating efficiencies, to provide“one-stop” shopping for their borrowers, orsimply to pool scarce capital.The creation of Agricultural Credit Associations(ACAs) through mergers of PCAs andFLBAs or FLCAs raised the question ofwhether the tax exemption for income generatedfrom mortgage lending extends toACA mortgage portfolios. Congress did notaddress this issue in the 1987 Amendmentsto the 1971 Act, and a number of institutionschose not to form ACAs because ofuncertainty over this issue. In 1996, whenthe issue was raised to the national office ofthe Internal Revenue Service (IRS), the IRSissued a memorandum advising that, in theabsence of an express statutory exemptionfrom taxation, ACAs should be consideredfully taxable.In 1997, the Farm Credit System made provisionsof $186 million for income taxes on$1,453 million in income for an effective taxrate of 13 percent, compared with a statutorytax rate of 35 percent for C corporations.The System estimates that it wouldhave paid an effective rate of 21 percent ($104million more 1 ) had not 61 FCSIs elected tofile under Subchapter T of the IR Code.This article examines the tax implicationsof various organizational structures availableto Farm Credit System institutions (FCSIs)and their commercial bank counterparts. Welook at the rapid increase in use of SubchapterS by commercial banks, the current useof Subchapter T by the FCSIs, and comparethe financial implications of each. Finally,we examine the combined tax effects for thebank and the borrower, and analyze the totaltax effect of various organizational structuresto the ultimate beneficiary, the farmer.Table 1Tax Filing Status of Farm CreditSystem InstitutionsJanuary 1, 1998InstitutionsTax Filing Status Number PercentTaxable, Subchapter T 61 30Taxable, Subchapter C 65 32Tax-exempt 77 38Total 203 1001. “Farm Credit System: Annual Information Statement-1997,” FederalFarm Credit Banks Funding Corporation. February 25, 1998.Page F-28.

FCA 1998Mid-Year Report20Recently many commercial banks receivedan opportunity to avoid double taxation, atboth the corporate and the shareholder level.The Small Business Job Protection Act of1996 gave certain financial institutions theoption of converting to Subchapter S corporationsfor the first time. A Subchapter Scorporation, like a partnership, is generallynot subject to Federal income tax at the corporatelevel, passing its income and expensesthrough to its shareholders in proportion totheir stock ownership. This option reducesthe bank’s taxes and increases after-tax earnings,much like the Subchapter T option.By September 1997, the Federal DepositInsurance Corporation (FDIC) reported that585 commercial banks had converted toSubchapter S, saving themselves an estimated$190 million in taxes. As of March 1998,over 400 more banks had converted. Todayover 1,000 banks, ranging in assets from $12million to $1.2 billion, or about 10 percentof all commercial banks, claim Subchapter Sstatus. Since, only 58 banks filed SubchapterS tax returns for tax year 1995, this representsa significant increase over the past threeyears. Many of these commercial banks aresmall rural banks that will pass their tax savingson to their owners and customers, increasingthe competition for FCSIs that competefor some of the same loans. Figure 1shows the distribution of Subchapter S banksby state as of March 31, 1998; most are locatedin the central states, with the heaviest concentrationsin Minnesota (146) and Texas(144).Figure 1Number of Commercial Banks filing under Subchapter Sas of March 31, 1998Source: FDIC

FCA 1998Mid-Year Report21Business Structures and TaxationThe sole proprietorship is the most commonlyused organizational structure forAmerican businesses. Its advantages aresimplicity and single-level taxation. Its primarydisadvantage is the potential legal liabilityto which the proprietor is exposed.Taxes are computed by totaling gross incomefrom all sources and subtracting deductionsto arrive at adjusted gross income (AGI).Taxable income is computed by subtractingitemized or standard deductions from AGI.Taxable income is then subjected marginallyto income rates ranging from 15 to 39.6percent, the latter rate being imposed for annualincome in excess of $271,000.The partnership is another common organizationalstructure employed by U.S. businesses.Like a sole proprietorship, it is simplein form. Its income and expenditures flowthrough to the partners, who are taxed atthe individual level. Its primary disadvantageis the potential legal liability to whichthe partners are exposed. The partnershipfiles an informational return explaining theallocation of income and deductions amongthe partners. Income and deductions arethen shown on the individual income taxreturn, where the actual tax due is computed.The limited liability company (LLC),although a relatively recent innovation, isnow a common form of business organization.These state-chartered entities providetheir owners with the limited liability of acorporation and the single tax treatment ofa partnership. Pass-through tax treatmentis provided for under Subchapter K of theIR Code. LLC owners are called members,as in a cooperative structure, but the LLC isa state-approved, unincorporated association.A general business corporation, or C corporation,is the most easily recognized formof business structure in the world. The Ccorporation is an entity separate from itsowners, providing a stable organizationalstructure that can outlive its owners as wellas provide them with legal liability protection.The C corporation is subject to incometaxation in its own right. Corporate incometax rates generally range from 15 to 35 percent,with the higher rates being applied totaxable income brackets of over $100,000.Corporation profits distributed to stockholdersas dividends are included in their grossincome. Consequently, corporation profitsare subject to taxation at the corporate leveland again at the shareholder level when distributedas dividends.Subchapter S corporations, named after theIR Code section that affords them special taxtreatment, are closely held corporations withfewer than 75 shareholders. Although theyare required to file tax returns like other generalbusiness corporations, if they meet certaincriteria they can elect to be taxed as apartnership. Unlike C corporations, these Scorporations are not taxed at the corporatelevel. Instead, their income and expenseitems are passed through to the shareholdersto be reported on their individual incometax returns. By electing S status, a corporationmay avoid double taxation of incomedistributed to its shareholders. The SubchapterS rules also dictate specific levels of cashpayouts for dividends and set forth criteriafor how allocated and unallocated equitiesmust be recorded on the company’s books.The Small Business Job Protection Act of1996 made the Subchapter S filing optionavailable to commercial banks, offering themroughly the same advantage of single taxationof dividends that Subchapter T filingdoes for cooperatives.Subchapter T corporations are cooperativesthat, by meeting certain criteria, can excludefrom income patronage dividends paid inmoney, property, or qualified written noticesof allocation. The cooperative notifies theIRS of the dividend payment on Form 1099-PATR, and the patron is then taxed on that

FCA 1998Mid-Year Report22amount. Distributions are based on thequantity or value of business done, ratherthan on stockholder equity as is the case withSubchapter S corporations.Subchapter T applies to any corporation operatingas a cooperative, and covers tax treatmentof cooperatives and their patrons whoreceive patronage dividends. Somecooperatives, including farmers’ marketingand purchasing cooperatives, are classifiedexempt and are not taxed. However, mostcooperatives, including some FCSIs, are taxedthe same as any ordinary business corporationat regular corporate rates, with the significantexception that cooperatives filingunder Subchapter T may deduct qualifiedpatronage distributions from income.The IR Code recognizes that cooperativesprovide services at cost; therefore, refunds ofnet margins to patrons are subjected to federalincome taxation only once. Patronagemust be allocated based on the quantity ofbusiness transacted with the cooperative, apreexisting obligation before the earningsbegin, and the net earnings derived frombusiness conducted with or for thecooperative’s patrons. Patronage dividendsallocated by the cooperative may be deductedin calculating its taxable income if the patronagrees to include the same amount in his orher income tax liability. This agreement maybe established in any of three ways:1. Through the cooperative’s bylaws.2. By written consent signed and furnishedbefore the end of the taxable year.3. By endorsing and cashing a qualifiedcheck. A qualified check bears a notice thatendorsing and cashing the check constitutesconsent by the patron to include thepatronage dividend as part of his or hertaxable income.If all taxable earnings are distributed, theSubchapter T institution pays no taxes andthe borrower/shareholder assumes the totaltax liability. Alternatively, a cooperative mayretain up to 80 percent of its declaredpatronage dividend tax-free at the corporatelevel. If a non-cash allocation is declared, aSubchapter T institution must distribute(allocate) a minimum of 20 percent of theearnings in cash to defray its shareholders’anticipated tax expenses. In this case thepatron would pay taxes on the total patronagedividend, and the FCSI would retain theallocated portion as a capital investment. 2Figure 2FCS Tax Filing Status by DistrictNumber of Institutions2. Under Farm Credit Administration (FCA) regulations, this capitalmust be retained for more than 5 years for it to be counted as coresurplus. Even then, it cannot be counted as core surplus whenthe revolvement cycle declines to 3 years or less. FCSIs mayclaim a refund for taxes paid on nonqualified patronage dividendsin the year of actual distribution.

FCA 1998Mid-Year Report23Under Subchapter T, retained earnings allocatedto patrons on the books of the associationbecomes borrower capital. Revolvingschedules may or may not be required,depending on how much borrower capitalthe association wants or needs to include inits permanent capital calculation. However,borrowers may expect that these allocationswill ultimately be paid out in true cooperativefashion, and association managementmay therefore view the capital as somethingthat will eventually need to be replaced.There are approximately equal numbers ofFCSIs that are tax-exempt, filing as C corporations,or filing as Subchapter T cooperatives.The 61 institutions filing underSubchapter T—30 percent of all FCS associations—arespread across almost every districtas shown in Figure 2.Effects of Different Tax Structureson Farm Credit System Institutionsand Their PatronsFCSIs that are subject to taxation can choosethe tax filing status that best suits their longtermgoals. This will have an effect not onlyon taxes paid, but it can also effect the capitalposition and the interest rates the institu-tion charges its customers. The actual effectof an institution’s converting to SubchapterT status depends on how much of its incomethe institution pays in dividends and on thecombined tax rates of the institution and itsvarious owners. Although it is not a taxexemption, conversion to Subchapter T statusgenerally produces a reduction in the combinedtaxes paid by the institution and itsowners. This article is primarily concernedwith analyzing the tax consequences of usingthe different filing methods. It should benoted that the comparison of tax treatmentsdemonstrated in Table 2 below makes rathersimplistic assumptions regarding distributionof income in order to compare the net taxespaid by both the institution and the patron.In Table 2, a cooperative doing $10,000 inbusiness on behalf of its patrons has incurred$9,000 in expenses and has $1,000 in incomeafter expenses. It has met all of the requirementsfor Subchapter T tax filers. It mayissue a qualified written notice of allocationto its members by sending them $280 (tocover a 28% personal tax liability) in cash orqualified check and a notice of allocation for$720. The patrons pay taxes on the allocationand may redeem their equity investmentof $720 at some time in the future. TheTable 2Tax Treatment of Cooperative Business Structure (T) and General BusinessCorporation Structure (C)General BusinessCooperative Structure Corporation StructureCooperative Patron Corporation StockholderGross Income $10,000 $10,000Expenses 9,000 9,000Taxable income 1,000 1,000Corporate income tax 1 0 350Qualified allocation/income declared $1,000 $650Cash dividend 280 650Individual income tax 2 280 182After-tax income 720 468Total taxes paid $280 $5321. Effective rate of 35% assumed. No allowance made for state income taxes.2. Effective rate of 28% assumed. No allowance made for state income taxes.

FCA 1998Mid-Year Report24Table 3Tax Treatment under Alternative Organizational StructuresC Corporation S Corporation T CooperativeTaxable income $1,000 $1,000 $1,000Corporate income taxes 350Average dividend/qualified patronage paid 455 455 400Retained earnings 195 545 600Individual income tax due 127 280 280After-tax cash flow to owner 328 175 120After-tax income to owner 523 720 720Total taxes paid $ 477 $ 280 $ 2801. Effective rate of 35% assumed. No allowance made for state income taxes.3. In 1997, FDIC Call reports showed that 70 percent of after tax netincome of banks was paid out in stockholder dividends.cooperative retains and continues to utilizethe $720, if it so desires. A C corporation, onthe other hand, would pay tax on its $1,000income. The comparison in Table 2 showshow Subchapter T election minimizes overalltaxes paid. In this example it was assumedthat the corporation had no retained earnings,a reflection of investor pressure onmanagement to maximize dividend distributions.In reality the total taxes paid willvary from case to case depending on stateand Federal tax rates and earnings retention,but the relative effects will remain the same.In this example, the tax treatment affordedthe cooperative with single taxation at theindividual level results in less taxes paid thanby a corporation taxed at both the corporateand individual levels. Total tax for the cooperative/patronstructure is $280, and $720 canbe retained at either the cooperative or individuallevel, while total tax for the corporation/stockholderstructure is $532, and $468is retained at the individual level.If the corporation elected to pay a smallerdividend, the effects of double taxation wouldhave been reduced, with a correspondingincrease in capital retained at the corporatelevel. However, even if the corporation didnot pay any dividends in the example cited,the $350 it paid in taxes is more than the$280 paid by the cooperative and its patroncombined. It is interesting to note that anFCSI that declares no dividend, but retainsall its surplus and an FCSI that pays a cashdividend of 35 percent may have similar cashflows. Both have 65 percent of their surplusremaining for whatever needs may arise.Table 3 compares the tax consequences ofthree organizational structures currently usedby banks or FCSIs. Dividends or patronagepaid is based on the amount of income historicallydistributed (or dividends paid) byeach. By projecting the tax consequences ofa commercial bank filing under SubchapterS, Table 3 highlights the competitive situationof financial services firms filing undereach of these organizational structures.In this example, a bank filing as a C corporationearns before-tax net income of $1,000in a given year and pays corporate incometaxes of $350. That leaves after-tax netincome of $650. The $455 stockholder dividendused for banks under Chapter C andSubchapter S represents the average bankstockholder dividend paid in 1997, accordingto the FDIC 3 . The Subchapter T corporationrepresents an FCSI that declares a$1,000 patronage dividend but retains $600for growth and expansion. Underlyingassumptions are generally consistent with theprevious example except that dividends distributedare consistent with current practices.

FCA 1998Mid-Year Report25We also assume that taxable income is thesame as net income before taxes and that allnet income is allocated.Given the broad assumptions made, itappears that Subchapter S can produce significanttax savings for commercial banksand the tax savings will be essentially thesame as those that FCSIs achieve using SubchapterT.Organizational Options for FarmCredit System InstitutionsFCSIs have a variety of options when it comesto choosing a tax strategy. In addition tomaximizing their tax advantages, other factorsinfluence this choice, including managementphilosophy, capital position, marketshare, and competition issues. The threescenarios in Table 4 illustrate how using differenttax structures can minimize the combinedtaxes paid by the FCSI and the shareholder.We assume that all income is paid tothe shareholders in order to maximize thenet tax savings to the ultimate beneficiary,the farmer/borrower. In reality, how aninstitution chooses to manage its earningswill in part depend on the taxes it expects topay. FCSIs filing as C corporations may notchoose to distribute all their earnings toshareholders, but rather may choose to retainmore capital or return the savings to theircustomers in the form of lower pricing strategies.These types of decisions typicallyinvolve more than the simple tax analysisdiscussed here. However, this example isnarrowly constructed in order to analyze thetax consequences of the different filingoptions for FCSIs and to compare with theSubchapter S case for commercial banks.In order to analyze the tax consequences ofpossible organizational structures available toFCSIs, we look at three types of institutionsthat have both long and short-term assets.The first scenario illustrates an FCSI withboth long and short-term assets (such as anACA) filing as a C corporation. The secondshows a jointly managed institution (such asa PCA/FLCA) where the short-term assetsare taxed as a C corporation and the institutiondoes not pay taxes on its long-termassets. The third shows an FCSI with bothlong and short-term assets (such as an ACA)filing as a Subchapter T cooperative.Consistent with our earlier examples, weassume a corporate tax rate of 35 percentand a personal tax rate of 28 percent. Forthe PCA/FLCA scenario, we assume the realestate portion of the portfolio is 56 percent,and income is allocated proportionately at56 percent for the FLCA assets and 44 percentfor the PCA assets 4 . We assume that allafter tax earnings are paid out as dividendsto shareholders.As shown in Table 4, total taxes paid by boththe FCSI and its owners are minimized inthe Subchapter T example (28 percent) comparedto the PCA/FLCA example (39.4 percent)or the C corporation example (53.2percent).Alternatively, when an FCSI wants to retainmore capital to facilitate growth and implementlong-term strategies, it can declare aqualified patronage dividend, paying out acash dividend of at least 20 percent and awritten notice of allocation for the balance.This would be the same as the example above,with the exception that the FCSI would retainthe $720. The patron would get the $720 incash in a future year when the qualifiednotice of allocation is redeemed.Another option is for the FCSI to declare anonqualified patronage dividend. In thisscenario, the FCSI, not the patron, pays thetax on the retained surplus. However, in subsequentyears, when the institution pays outthe money represented by the nonqualifiednotice to the patron, the institution files fora refund of taxes previously paid on the surplus,and the patron pays taxes on the dividendreceived. Again, this is similar to theexample above, except that the income and4. Based on actual System performance in jointly managed associations.

FCA 1998Mid-Year Report26Table 4Tax Treatment of Alternative Organizational Structures Available to FarmCredit System InstitutionsJointly ManagedPCA/FLCA(C Corporation/ Subchapter TC Corporation Non-Taxable) CooperativeIncome before taxes $ 1,000 $ 1,000 $ 1,000Pro-rata share ofincome to PCA/FLCA 440/560Corporate income taxes (35%) 350 154Taxable net income to owners 650 286 1,000Average dividend/qualified patronage paid 650 856 1,000Personal taxes on dividends (28%) 182 240 280After-tax cash flow to owner(dividends - personal taxes) 468 616 720Total taxes paid $ 532 $ 394 $ 280tax effect on the individual patron is delayedfor a period of years, until the nonqualifiednotice is redeemed. In this latter strategy,the undistributed retained earnings can becounted as core capital under FCA regulationsuntil the earnings are allocated anddistributed.Effects of Filing Status on FinancialConditionThe choice of corporate form will normallyeffect an institution’s behavior. For ownersof C corporations, there is an incentive tokeep patronage refunds low and either retainafter tax earnings to build capital, or to lowerinterest rates charged borrowers, thereby loweringtaxable income. In contrast, highpatronagedividend payouts are relativelymore advantageous in the management of Tassociations’ earnings. Thus, one mightexpect Subchapter T associations to havelower levels of capital on average. However,no significant differences were found in thefinancial ratios for FCSIs when comparedbased on their tax filing status as of March 31,1998. On average, FCSIs had similar coresurplus, permanent capital, and total surplusratios, regardless of tax filing status, as shownin Table 5. This may be due in large part toregulatory capital requirements.The tax benefits of filing under SubchapterT seem considerable for those institutionswith both long- and short-term lendingportfolios that want to minimize their taxes.Institutions converting to Subchapter T statuscan (and apparently do) retain some ofthe tax savings as higher capital levels. Theinstitution owners reap some of the tax savingsdirectly through patronage taxed at onlyone level. FCSI owner-borrowers realizelower effective loan rates as equity investmentsare revolved out to patrons.

FCA 1998Mid-Year Report27Table 5Selected Financial Ratios by Tax Filing Status for Farm Credit SystemInstitutionsC Corporation Subchapter T Tax-ExemptCore surplus 10.5% 11.5% 12.8%Permanent capital 18.5% 18.5% 16.6%Total surplus 14.5% 15.1% 14.2%Allowance to loans 2.8% 2.8% 1.8%Other Pros and ConsMany FCSIs believe Subchapter T filing providesthem with a valuable tax managementtool, and they enjoy the obvious benefits ofsingle taxation. Because benefits are passedon to patrons through patronage, this meanslower effective loan rates for borrowers.Some FCSIs have been able to rebate almosttwo-thirds of the annual interest due. As aresult, these FCSIs have been able to pricetheir loan rates at market rates and cite fewerpricing complaints from competitors. By settingtheir revolving surplus cycle at greaterthan 5 years they are able to claim a portionof the surplus as core capital. They alsobelieve that the cooperative structure andrelated patronage help build owner interestand customer loyalty.Many FCSIs file as C corporations and aretaxed at regular corporate income tax rates.Dividends, if paid, are taxed again at the regularindividual income tax rates. However,many FCSIs filing as C corporations do notpay patronage dividends. Because the maximumtax rates for corporate taxpayers andindividual taxpayers are similar, they see norelative advantage to shifting the tax burdenfrom the FCSI to the patron. In fact, theysee a distinct disadvantage to paying patronagedividends. In their view, it creates theexpectation among patrons that allocatedequities will always be revolved out, regardlessof the need at the cooperative level.Hence, payouts detract from the value of thesurplus and an FCSI’s ability to expand andgrow. They believe that patronage dividendsshould be paid only if capital is adequate andcan be sustained over time or can be viewedas a rebate on interest payments by the borrower.Implications of Tax Law ChangesSmall, investor-owned banks with fewer than75 shareholders have only recently been givenauthority to reorganize as Subchapter S corporations.Commercial banks that elect toconvert will pass through all of the incomeand expenses associated with their operationsto their stockholders, achieving one-leveltaxation and a higher level of capital availableto retain or reinvest.The implications for FCSIs are significant. Atax advantage available to all FCSIs butclaimed by only half will now be available tomany competing rural and communitybanks. They may choose to pass on all, some,or none of these tax benefits to their customers.If any of these benefits are passed

FCA 1998Mid-Year Report28on to customers, it will result in stiffer competitionfor agricultural loans for FCSIs, especiallyif they are unable to take advantageof the Subchapter T benefits currently availableto them.Also on the horizon is legislation proposedin July 1998 that would let a company qualifyfor S corporation status if it has no morethan 150 shareholders. If enacted, this legislationwould expand eligibility and, withother proposed changes, make it easier forsmall banks to convert to S corporations.This added tax relief will make them morecompetitive with FCSIs. Currently 1,009, approximately25 percent, of small commercialbanks (those with assets less than $150 million)have converted to S corporations. Thatleaves another 3,000 potential candidates forconversion. 5In SummaryThis article demonstrates that- The Subchapter T can minimize taxesand is used by half of the taxable FCSIs.- Commercial banks have begun to convertto Subchapter S Corporations allowingthose institutions to enjoy tax benefitssimilar to Subchapter T.- Other factors such as capital position,dividend distribution, and managementphilosophy will need to be considered inselecting the most advantageous organizationalstructure.5. Conversion is gaining in popularity, as is evidenced by inclusionof this topic in the American Bankers Association’s fall 1998annual meeting agenda.

Risks Associated with the MillennialDate ChangeFCA 1998Mid-Year Report29Thomas Glenn and Robert AndrosIntroductionThe year 2000 problem, or the ability of someautomated systems to comprehend datesbeyond 1999, poses a serious challenge forthe financial services sector, including FarmCredit System institutions. Overall, the FederalReserve has warned that the Y2K problemmay bring about an economic slowdown(or worse, according to some analysts) asfirms are required to divert resources to “nonproductiveendeavors.” On an operationallevel, each FCSI faces a series of risks associatedwith the millennial date change: in itscomputer systems; embedded systems; supplier,client, and servicer interfaces; customerrisks and related ripple effects; infrastructure,and government services.The Farm Credit Administration has providedtimely and comprehensive guidanceto FCSIs at both the general and individualinstitution levels. All FCSIs had madeprogress toward Y2K remediation during thesecond quarter of 1998. Nevertheless, failureto adequately address each area of risk successfullycan increase the potential for legalliability. If Congress does address the issueof a Y2K liability cap for businesses, it willalso need to establish what criteria need tobe met to qualify for the limitation. Thesecriteria may include that firms demonstratethey employed “best management practices”or that they provide independent certificationthat all systems were fixed using a wellreasonedand comprehensive methodology.Operational RisksThe principal areas of operational risk thateach institution or organization faces are:• Computer systems. Almost all databaseswithin financial institutions are computerized.Computer hardware, firmware, andsoftware (application programs) all havethe potential to malfunction or refuse tofunction altogether on January 1, 2000.Moreover, different computer systems,some of which may use different programminglanguages, often coexist within thesame institution, and these systems’ interfacesmay require compatible, if not consistentremediation methods. Functionsserved by these computer systems includecalculating interest, dividends, maturities,and amortization schedules, electronic datainterchange, and automated clearinghouseactivities.• Embedded systems. These are individualor small assemblies of microprocessorsused to control, monitor, or assist theoperation of equipment or machinery.They do not necessarily involve a computerand are therefore not obvious to theuser. Embedded systems are generallycapable of performing only a predeterminedsingle function or set of functions.Some have a timing function while othersdo not. Frequently, the only way to determinethese systems’ Y2K compliance is bystudying their documentation or contactingthe vendor. Common examples ofequipment with date-sensitive embeddedsystems include telephone systems, fax machines,vaults, security and alarm systems,microwave ovens, videocassette recorders,and automatic teller machines (ATMs).While most companies have recognizedthe problem and begun assessing the Y2Kcompliance of their computer systems,experts have expressed concern that embeddedsystems have not been given thesame level of scrutiny as computer systems.• Interfaces. Like other financial institutions,many FCSIs are dependent on third-partyservicers for some or all of their computerprocessing needs. Most financial servicesinstitutions are dependent on suppliers,customers, and vendors for data input andprocessing of their own data. Examplesinclude a customer who banks by computer,a correspondent bank that billsdirectly through a client bank’s computerE ach Farm Credit System institution facescertain risks associated with the millennialdate change. Because of their pervasivenature, these risks may not be self-evident.This article describes these vulnerabilities,explains how they may affect an FCSI, andsummarizes FCA guidance issued on thesubject. It also describes what actions anFCSI can take to mitigate against these risks,especially that of legal liability, and theirpossible consequences on an institution.

FCA 1998Mid-Year Report30system, and the Federal Reserve’s Fedwiresystem, which handles payment, clearing,and settlement functions for memberbanks via computer. Many firms have alreadyexperienced Y2K problems in theirfinancial services. For example, ProducePalace, a gourmet food outlet in Michigan,found that credit cards listing 2000 astheir expiration date caused the store’scomputer system, installed only two yearsago, to crash more than a hundred times,often for several hours at a time. This costthe store lost revenues as it attempted toprocess its transactions manually. In theend, Produce Palace sued its credit cardscanner supplier for damages. Severalcommercial banks have experienced similarproblems with their ATMs. Eventhough all of a bank’s computer systemsmay be fixed to accept the millennial datechange, their interfaces pose a separaterisk and require separate testing.• Customers. A financial institution isespecially dependent on the success of itsborrowers and the composition of its balancebetween assets on hand and customerneeds. Financial regulators are becomingincreasingly concerned over the Y2K complianceof bank customers, especially smallbusinesses, and the possible effects of theirY2K noncompliance. Many large businessesare also openly concerned about theY2K compliance of their suppliers, particularlysince “just-in-time” inventory schedulingis a common business practice today.Although this practice reduces costs,it makes no allowance for business outages,the results of which can prove catastrophic.Even the potential ripple effecton a financial institution of a large customerfailing to obtain timely suppliesfrom a small business that is not Y2K compliantis significant. A business risk facedby a bank’s business customers, as well asthe bank itself, is a possible loss of consumerconfidence and the resultant loss ofcustomers that can mean failure for a firm.In addition, foreign countries are reportedlyway behind in their Y2K remedialefforts. Because agricultural producers arelargely dependent on foreign export markets,this may be another potential ripplethat requires monitoring. Finally, a numberof FCSIs that needed to improve theirY2K efforts have not adequately assessedthe risk of the millennial date change ontheir customers’ operations. Some financialinstitutions are therefore concernedabout a possible liquidity imbalance onJanuary 1, 2000, leading to a potential liquiditycrunch.• Infrastructure. Financial institutions havean internal and an external infrastructure.Internal infrastructure components includeelevator, heating, air conditioning,telephone, and security systems. Externalinfrastructure components include transportationnetworks, telecommunicationsystems, and local utilities such as electricpower, gas, water, and sewer facilities. Eachof these components will face its own specificset of Y2K compliance risks when themillennial date changes. Many of thesecomponents rely heavily on embeddedsystems.• Government services. All financial institutionsrely on government services. Theserange from regulatory approvals and checkclearing and settlement systems to agenciesthat employ electronic fund transfers.Any Y2K noncompliance by these governmentagencies (whether at the Federal,state, or local level) in their critical systemscould adversely affect a financialinstitution’s performance.Surveys show that most financial institutionshave found it necessary to hire outside technicalsupport to assist in their Y2Kremediation efforts. These outside resourcesare limited, however, and some prominentcomputer consulting firms have announcedthat they will not take on additional Y2K cli-

FCA 1998Mid-Year Report31ents because of the potential legal liability towhich their firms might be exposed. To date,Coopers and Lybrand has been the only BigSix accounting firm engaged in Y2Kremediation work, and it is reportedlyreviewing its position on this issue subsequentto its merger with Price Waterhouse.Hence, reliable resources will be a scarce andcostly commodity for firms that needlesslydelay launching their remediation activities.A significant decision facing all financialregulators is if and when to require a mergeror takeover of financial institutions that arenot Y2K compliant. Unfortunately, authoritiesand approaches for dealing with troubledinstitutions vary from one regulator toanother. On the international front, the Bankof England has announced it would closedown banks found to be Y2K noncompliant.U.S. regulators, on the other hand, have beenuncomfortable with setting arbitrary “dropdead” dates, preferring instead to deal withproblem institutions on a case-by-case basis.On the other side of the fence, the problemfacing the absorbing institution is whether ithas enough time to assimilate anoncompliant bank’s customers into its ownsystem to avoid potential legal liability foritself. Hence, regulators have to considerthese needs when deciding what constitutestimely supervisory action. The bottom linefor each regulated financial services institutionis that remediation efforts cannot bedelayed. Both Congressional staff and GAOare encouraging regulators to take a proactiveapproach by anticipating any need for mergersprior to January 1, 2000, rather thanwaiting for financial institutions to fail theircustomers before taking action.Liability RisksPerhaps the thorniest Y2K issue has yet to beaddressed, much less resolved. Both witnessesin congressional hearings and Lloyd’sof London have estimated that Y2K litiga-tion costs and damages will exceed $1 trillionin the United States alone. What’s more,firms may be vulnerable to court suits andrelated damages not just for their own actionsbut for those of their business partners aswell. Potential liability for FCSIs may comefrom a number of different sources, includinginvestors, customers, business partners,and other third parties. These parties relyon the integrity of FCSI data, the stability ofSystem operations, software vendors, andmaintenance providers, flawless FCSI mergerand acquisition activities, and more. Liabilitytroubles that may surface include:• Director and Officer Liability. Bank officersare subject to the stringent criteria ofethics and fiduciary duty. Bank executivesand directors may find themselves facingsevere personal liabilities unless their Y2Kproblems are safely contained within theirinstitutions’ operations. To avoid personalliability, directors and officers are requiredto meet applicable legal standards of carein taking action to solve Y2K problems intheir institutions. While FCSIs may havedirector and officer liability insurance,some insurance companies have openlyquestioned whether their policies willcover known management problems suchas Y2K noncompliance.• Disclosure Issues. The Securities andExchange Commission (SEC) Staff LegalBulletin Number 5 requires certain Y2Kdisclosures by publicly traded firms. Todate, the legal bulletin has not induced thetypes of disclosure the SEC and Congresshad anticipated. As of June 30, 1998, only85 of the 500 largest publicly traded U.S.companies had disclosed their estimatedY2K costs. Legislation (S.1518, the ComputerRemediation and Shareholder ProtectionAct, or CRASH) has been introducedthat would mandate full Y2K disclosureby publicly traded firms. Whilethis does not affect Farm Credit System

FCA 1998Mid-Year Report32institutions, it will set a standard of performanceagainst which they may bejudged. FCSIs have also received guidanceon disclosure of Y2K costs from FCA’sChief Examiner. The Federal Financial InstitutionsExamination Council (FFIEC)has recently cautioned that ”A financial institutionmay reduce its risks of litigationif it discloses to beneficiaries informationaddressing the Year 2000 date change.”Omissions, inaccuracies, or misleadingstatements regarding an institution’s Y2Kdeficiencies may be cause for legal actionby investors or stockholders under Federaland state securities laws. Public auditorsare concerned that if they fail to raisethe issue they may make themselves legallyculpable. Due diligence investigationsare generally required before an investmentis made. Investors are now being madeaware of their fiduciary responsibility tocheck on the Y2K compliance of firmssoliciting funding. These representations,or lack thereof, could increase the cost offunds or expose institutions making themto potential liability.• Client Risk. The financial performance ofFCSI clients may expose System institutionsto some liability. Many of theSystem’s clients are not subject to the SECdisclosure rules, so the SEC is not a sourceof reliable information regarding clients.CRASH legislation is not likely to passsoon enough to provide FCSIs reliable andtimely information on key suppliers andbusiness partners. A number of firms haveresorted to sending letters requesting suppliers’and vendors’ assurances that theyare capable of meeting supply schedulesand are Y2K compliant. Responses to theseinquiries have been intermittent. Still otherfirms, such as General Motors and Texaco,have announced their intentions to makeon-site visits to key suppliers. Bankruptciesare a potential threat and among themost troubling problems presented by themillennial date change. Bankruptcies mayeasily occur among small, medium, ormarginally financed companies if the Y2Kproblem disrupts power, shipping, financialservices, export markets, or telecommunicationslong enough to harm cashflow. Bankruptcies can also threaten thesafety and soundness of financial institutions,which will need to determine howlong they can support customers’ cash flowproblems before requiring settlement andrisking customer goodwill. Some financialinstitutions, including FCSIs, are alreadyreviewing the Y2K compliance programsand contingency plans of their significantcustomers.• Contracts, Advertising, and CustomerAgreements. Financial institutions’ accurateand continuous operations are expectedby customers and business partnersalike. Some may even seek writtenconfirmation and verification of timelydelivery of various goods and services inanticipation of Y2K problems and to protecttheir own business positions. Advertisements,contracts, and written agreementsas well as consumer protection lawsmay expose FCSIs to liability. Moreover,false claims by vendors of Y2K remediationservices may expose a financial or otherinstitution to additional risk. Because thesoftware industry is not regulated, skilledresources are in scarce supply, and “proofof claims” is a rarity among software tooland service vendors, false claims may introduceanother potential liability to unsuspectingfirms. The GAO has alreadynoted a number of false claims of Y2Kcompliance among Government vendors,and the General Services Administration(GSA) has been unable to attest to the Y2Kcompliance of goods and services availablethrough the GSA supply schedule.

FCA 1998Mid-Year Report33• Documentation. Even if all necessaryplans and steps are undertaken toremediate or otherwise remove Y2K deficiencies,a firm and its officers and directorsmay ultimately need to prove theiractions in court. Failure to develop andmaintain documentation of an FCSI’s effortscould expose it to needless liability,as such documentation may be necessaryfor legal defense, insurance claims, andindemnification. Every System institutionshould review all of its insurance policies,contracts, and product documentation,including warranties, to see who bears thecosts of fixing Y2K problems and underwhat conditions. In licenses and agreements,Y2K compliance should be expresslyand explicitly addressed. An inventoryand review of licenses and agreementsmay identify vendors and softwaremanufacturers that have a legal responsibilityto help solve the problem or contributeto the cost of correcting it. A reviewof company insurance policies maydetermine whether the institution is coveredfor remediation costs, liability protectionfor directors and officers, casualtyand business loss, fiduciary activity, andaccounts receivable or other valuablerecord loss. Even the ability to expense orcapitalize remediation costs for tax purposesmay hinge on accurate and adequatedocumentation.• Third Party Risks. Aggrieved customersand business partners may sue not onlyY2K deficient firms but their key businesspartners (including auditors and creditors)as well. This could expose FCSIs and otherfinancial services firms to liability beyondtheir immediate control or sphere ofinfluence. In addition, FCSIs offeringautomated farm management services thatrely on software vendors and maintenanceproviders may be exposed to legal liabilityif the computer products they use are notY2K compliant, interfaces with customersdo not function as expected, orremediation efforts do not prove adequateor compatible with those of suppliers, vendors,customers, and others.• Other Risks. These include a range ofconcerns, such as Merger and Acquisition(M&A) and copyright issues associatedwith Y2K remediation. If a company isengaged in planning an M&A transaction,due diligence requires expert assistance todetermine the nature, extent, and potentialcosts of Y2K problems the companymay inherit. Like other regulators, FCAreviews corporate applications to ensurethat all conditions concerning the safetyand soundness of the FCSI, including Y2Kcompliance, are met. This is not only aconcern for FCSI mergers but for theinstitution’s customers as well. Anotherarea of concern for firms, as mentionedabove, is whether they have the legal rightto change copyrighted code to make it Y2Kcompliant without the softwaremanufacturer’s consent. In some cases themanufacturer may have gone out of business,merged, or no longer produces thesoftware in question. In other instances, itmay not want to grant a copyright exemptionto users.While Congress and the White House havediscussed limiting the liability exposure offirms that fall victim to various Y2K deficiencies,they have also expressed reluctanceto legislate a safe harbor, thereby creating amoral hazard. On July 14, 1998, PresidentClinton announced his intention to propose“Good Samaritan” legislation that wouldimmunize businesses from lawsuits if theyshare information about their common Y2Kproblems. However, the Chairman of thePresident’s Y2K Conversion Council, hasdescribed this legislation as “a narrow, carefullydefined bill.” To date two narrowlydefinedliability limitation bills have beenintroduced. The Administration’s “GoodSamaritan Bill” and a bill introduced in theHouse limiting punitive damages for com-

FCA 1998Mid-Year Report34puter and software companies. To date nocomprehensive Y2K legal liability legislationhas been introduced. Congressional leadershave indicated that any liability limitationlegislation will need to incorporate some performancecriteria, such as certification that afirm used best management practices, inorder for that firm to qualify for a liabilitycap.FCA Guidance and SystemPerformanceThe Farm Credit Administration has adoptedthe FFIEC’s Y2K rating system for Systeminstitutions. It also has provided FFIECguidance to FCSIs in a timely manner andaugmented that guidance where appropriate.The FFIEC, following the GAO and Officeof Management and Budget (OMB) guidelinesfor Federal agencies, has outlined fivemanagement phases (with target completiondates) necessary for an organization to completea successful Y2K system conversionprogram. They are:Awareness – to be completed by December1996.Assessment – to be completed by June 1997.Renovation – to be completed by December1998.Validation – to be completed by January1999.Implementation – to be completed byNovember 1999.The FCA Chairman’s May 14, 1998 testimonybefore the Senate Agriculture Committeehighlighted both the FCA’s and the System’sprogress in achieving Y2K compliance.Guidance issued by the FCA’s Office ofExamination (see list at right) as well as theJune 30 survey results indicate that both theFCA and the System are well under way inpursuing a timely resolution of the problemsposed by the Y2K technology problem.Year 2000 Guidance Issued toFCSIsYear 2000 Awareness. This informationalmemorandum provides guidance on thecritical issues FCSIs need to address to resolveY2K problems and avoid major servicedisruptions. It highlights the five phases ofremediation and establishes milestone datesfor their completion. Issued June 6, 1997.Disclosure of Year 2000 Costs. This informationalmemorandum provides guidanceon the disclosure of costs associated with Y2Kremediation efforts. Issued November 14,1997.Year 2000 Business Risk. This informationalmemorandum outlines director and seniormanagement responsibilities for addressingbusiness risks. It outlines and describes thetypes of Y2K-related business risks to whichFCSIs may be exposed. Issued January 8,1998.Expectations for Testing of Mission-CriticalSystems. This informational memorandumprovides additional guidance and details onrelevant milestone dates for testing missioncriticalsystems. Issued March 17, 1998.Service Provider and Software Vendor Year2000 Readiness. This informational memorandumprovides guidance on and establishesresponsibility for overseeing the Y2Kcompliance of service providers and softwarevendors with regard to mission-critical systems.Issued April 13, 1998.Year 2000 Impact on Customers of FarmCredit System Institutions. This informationalmemorandum addresses the risksposed by customer vulnerabilities to Y2Kproblems. It provides guidance for identifyingand documenting risks posed by materialFCSI customers. Issued April 23, 1998.

FCA 1998Mid-Year Report35Testing For Year 2000 Readiness. This informationalmemorandum provides guidanceon the types and nature of tests required toensure that Y2K remediation efforts are successful.Issued May 20, 1998.Contingency Planning for Business Continuity.This informational memorandumdescribes the types of contingencies, both internaland external to the institution, thatplans must address to ensure business continuitythrough the millennial date change. Italso establishes relevant milestone dates.Issued June 30, 1998.As of June 30, 1998, each FCA field office/division had completed an updated Y2K assessmentof each FCSI regarding the fivemanagement phases. Using the survey results,each FCSI was assigned a rating of “Satisfactory,”“Needs Improvement,” or “Unsatisfactory.”Because each of the managementphases has a time frame within which specificwork is to be accomplished, a satisfactoryrating for one quarter does not imply asatisfactory rating in subsequent quarters; itsimply means that the FCSI is currently ontrack to complete its remediation work bythe deadline. This dilemma was highlightedin February of this year when OMB took theU.S. Department of Labor off the list of Federalagencies making adequate progress andadded it to the list of agencies making insufficientprogress. Therefore, although theFarm Credit System is making progress, itmust continue on a fast track to ensure timelyand successful Y2K remediation.Overall, the survey results from the secondquarter of 1998 show marked improvementby FCSIs since the previous quarter. Moreimportantly, each FCSI showed improvementduring the most recent quarter. FCSIs rated“Unsatisfactory” declined from 74 in the firstquarter to only 2 in the second quarter, orless than 1 percent. Institutions rated “Satisfactory”increased from 71 in the first quarterto 133 in the second quarter. Among the81 FCSIs that were rated “Needs Improvement,”a common weakness was the lack ofadequate effort to identify borrowers whoseoperations may be adversely impacted by themillennial date change. This issue was highlightedand specific guidance provided in anApril 29, 1998 letter from the Chief Examinerto each FCSI. Those rated “Needs Improvement”also demonstrated lingeringproject management weaknesses, the absenceof an effective Y2K audit program, or a latestart that means they are still “playing catchup” on the project. Each of these institutionsreceived specialized and specific guidancefrom FCA examiners on how to improvetheir Y2K compliance.Because the Farm Credit System is classifiedas a single Government-sponsored enterprisewith jointly managed funding, there is interdependencewithin the System. FCA thereforeundertook to determine which FCSIswere “high-profile” institutions that requiredspecial monitoring. High-profile institutionsare the primary data centers for the FarmCredit System, and they develop, maintain,and control most of the Systems’ missioncriticalsystems. Low-profile institutions generallycontracted with a high-profile counterpartto maintain their mission-critical systems.None of the 20 high-profile institutionsis rated “Unsatisfactory,” and 80 percentare rated “Satisfactory.” This informationis important for System investors. Recently,legislation was introduced that emphasizesinvestors’ fiduciary duties and underscorestheir responsibility to evaluate theY2K risks of institutions in which they invest.Owing to the nature of the risks describedabove, FCA’s most recent focus has been oncontingency planning. Under guidance issuedby the Chief Examiner on June 30, 1998,each FCSI is expected to have a businesscontingency plan in place by the end of thisyear. These plans need to address both thepossibility of internal system failure and thepossibility of external system failure fromservice providers, software vendors, other

FCA 1998Mid-Year Report36institutions, customers, business partners,utilities, etc. These Y2K plans are to be designedto ensure that mission-critical systemscan continue to function despite potentialY2K system failures.ConclusionIt is impossible for any financial services firmto insulate itself entirely from the repercussionsof the millennial date change. At aminimum, adverse economic effects are likelyto be felt within the Farm Credit System andamong its customers. There will be a transferof business between Y2K compliant andnoncompliant firms. The financial servicessector will be exposed to the business risksof its customers, some of whom may eitherfail to perform successfully after themillennial date change or simply lose theconfidence of their consumers who seekother business partners and vendors.The financial services sector is highly dependenton date-dependent automated services.While FCSIs seldom face the complex problemsassociated with embedded systems, theyare highly dependent on interfaces with suppliers,vendors, servicers, and others. Formost firms, testing these interfaces is notlikely to be possible until the fourth quarterof 1999, leaving little time for last-minute corrections.Contingency planning for FCSIswill become increasingly important.liability. Many challenges and obstacles lieahead for financial service institutions andtheir respective regulators. The January 1,2000 deadline is an unyielding time constraint.For institutions unable to meet thisdeadline and even for some that do there liesthe prospect of court suits and other legalliability posed by various Y2K deficiencies.While there has been discussion concerninglegislating a liability caps for firms that followbest management practices to remediatetheir Y2K problems, there is also oppositionto legislating a liability cap. If no legislationis passed, it will fall to each FCSI to developsufficient documentation of its remediationefforts to defend itself against potential lawsuits.Whether in response to legislative criteriafor liability limitations or in response toa court suit, FCSIs may benefit from independentcertification that their remediationplans were consistent with regulatory guidance,comprehensive and thorough, and carriedout in their entirety. System institutionsmay mitigate their liability exposure if theyfollow FCA’s Y2K guidance and documentthat they did so.As an arm’s-length regulator, FCA is in aunique position to provide both value-addedand important support and assistance toFCSIs in their quest for Y2K compliance.Diligent adherence to the Agency’s guidanceand direction will assist FCSIs seeking tominimize or otherwise limit their legal

Effects of a Prolonged EconomicDepression in Southeast Asia on theU.S. Farm EconomyDr. Paul T. Prentice 1Farm Sector Economics, Inc.FCA 1998Mid-Year Report37IntroductionRecent prosperity in the U.S. farm sector hasbeen driven primarily by booming exportsto Asian markets, particularly to those emergingin Southeast Asia. In 1997, Farm SectorEconomics was forecasting continued prosperityfor U.S. agriculture, and presented thatoptimistic forecast in a series of regionalbriefings for the Farm Credit System. Thescenario was based on the assumption ofcontinued strong economic growth in theAsian markets.Now that those markets have collapsed, theforecast has changed from optimistic to pessimistic.Farm commodity prices continueto fall. In mid-August, the USDA was predictingthat farm income would decline by$7.4 billion in 1998 from the 1997 figure of$49.9 billion. From the 1996 level net farmincome is forecast to decline by $11 billion,representing a two-year income loss of 20percent. Unless new or revived export marketscan be found, farm income now looksto remain weak for at least two to three moreyears.As a result of this expected weakness, theFarm Credit Administration requested FarmSector Economics, Inc. to provide the Agencywith an assessment of the degree of risk associatedwith the Asian events and to providea model to show the effects of these risksunder different key economic variables in individualFarm Credit Districts. FCA was providedwith two updated forecasts: the 1998Baseline Scenario and a Continued AsianDepression Scenario. 2The 1998 Baseline Scenario forecast assumesthat the Asian economic problems, bad asthey are, will be resolved in 1999. We assumethe region will resume positive economicgrowth, although at a rate only abouthalf as fast as before.However, the Asian economic depressioncould be deeper, more widespread, and longerthan assumed in the Baseline. To betterunderstand this risk, the Continued AsianDepression scenario was developed.Overview of ResultsThe model’s 1998 Baseline Scenario is nowforecasting the first decline in U.S. farm realestate values sector-wide and in farm sectorequity since recovery began from the depressed1980s. The latest forecast (as of August1998) shows extremely weak real estatemarkets through the year 2002. As a result,the farm debt market is also forecast to beweak, with increasing financial stress occurringin the form of increased bankruptcies,deteriorating balance sheets, and, for lenders,more problem loans and loan losses.Although not predicted to be remotely assevere as the stress of the 1980s, the declinemarks the first serious long-run challenge tofarm financial performance since that time.A prolonged depression in the economies ofSoutheast Asia would have a profoundlynegative impact on the U.S. farm sector andon agriculture in each of the seven FarmCredit Districts. Using the model under theContinued Asian Depression scenario, U.S.net farm income would be reduced by anaverage of $2 billion per year, or 5 percentbelow the already-reduced Baseline forecast.The model also shows the effects of eachscenario on farm income, farm real estatevalues, and farm debt for the states in eachof the Farm Credit System’s seven districts.As an example, the model shows that the consequencesof the Continued Asian Depressionscenario would be more severe in theAgriBank Farm Credit District, where farmerswould receive an annual average of $529million less (4.1 percent) in annual net farmincome over the next five years. Most hardhiton a percentage basis would be theThis article shows how recent events in Asiahave significantly altered the forecast for farmincome and farm real estate values over thenext five years. Forecasted results are providedon a regional basis so that the effects on eachFarm Credit district can be revealed. In addition,the article reviews price forecasts for eachmajor farm commodity and shows how thesecommodity prices might be further reduced ifconditions in Asia continue to be depressed.1. The FCA has commissioned Dr. Prentice’s firm, Farm Sector Economics,Inc., to provide an outlook for the U.S. agriculturaleconomy and for the districts of the FCS. While the Agency doesnot necessarily endorse this specific outlook, we believe the informationpresented will be useful in helping System institutionsand other readers understand the effects of the recent events inAsia and make plans for their portfolios.2. Farm Sector Economics, Inc., calls the model it uses for these forecaststhe AGSEC Model

FCA 1998Mid-Year Report38Wichita District, where net farm incomewould be reduced an average of $173 million,or 6.1 percent, annually. The effectwould be least severe in the northeasternstates served by CoBank, with an annualincome loss of $10 million or 0.7 percent.The model does not account for the effecton fruits, vegetables, and specialty crops,thereby understating the loss in certain regions.In reality, the effect on these districtswould be much more severe, as Asia is amajor export market for these commodities.In addition, the model does not account forthe decline in foreign exchange rates versusthe dollar, which could also make conditionsworse than forecast.Fortunately, today’s external inflation andinterest rate environment is much more favorablethan in the mid-1980s when the farmfinancial collapse occurred. What’s more,farmers and their lenders are for the mostpart better positioned, both in their financialstrength and in their more conservativelending practices, to weather the storm.Unless the Continued Asian Depression Scenariogets worse, any extreme stress will belocalized and short-lived compared with thatof the 1980s.Market for Agricultural ExportsThe Asian markets averaged 48 percent ofthe value of all U.S. farm exports over the1995 to 1997. (See Figures 1 and 2.) Emergingcountries in the region had been averaging6 to 8 percent real economic growthduring the 1990s. (See Figure 3.) This astoundingeconomic growth led to a rapidupgrading of diets that, when combined witha large and growing population base, createda boom in demand for U.S. farm exports.This phenomenon, in turn, creatednew prosperity for U.S. farmers and theirlenders.Beginning in the summer of 1997 and continuingtoday, several Asian countries haveexperienced a collapse in their currenciesthat has resulted in economic depression.The situation is worst in Indonesia, Malaysia,the Philippines, Singapore, Thailand, andVietnam, but is also severe in Hong Kong,South Korea, and Taiwan. (For convenience,we define this entire set of countries as“Southeast Asia.”) Even more disturbing, theeffect has spread to the most developed economicpowerhouse in the region—Japan—which has fallen into recession in 1998 withweak prospects for recovery. The Interna-The Importance of the AsianFigure 1Major Commodities: Percent of U.S. Production ExportedAverage of 1995-1997PercentSource: USDA data.

FCA 1998Mid-Year Report39Figure 2U.S. Agricultural Production: Percent Exported by World RegionAverage of 1995-1997Figure 3S.E. Asian Annual GDP Growth: Three ScenariosGDP Growth (%)PercentSource: USDA Datational Monetary Fund (IMF) bailouts for theemerging economies may be too little, toolate. Moreover, the regional problems inSoutheast Asia could spread to the remainingbright spot for long-term farm exportexpansion — China. Hong Kong is alreadyofficially in recession. The collapse of theRussian currency and stock markets in lateAugust will only make matters worse. Weexpect that the Asian recovery will be slowand varied, unlike the relatively rapid Mexicanrecovery in 1995.Baseline Scenario AssumptionsThe Baseline Scenario used in this studymade the following assumptions:The most important change in the FarmSector Economics macroeconomic forecastsince the 1997 update is the collapse of theSoutheast Asian economies last fall. This willlead to a slowing of U.S. economic growthand rising unemployment, which will takepressure off what would otherwise be risinginflation and interest rates.

FCA 1998Mid-Year Report40• The 1998 Baseline forecast assumes thatthe Asian economic problems, bad asthey are, will be resolved in 1999. Weassume the region will resume positiveeconomic growth after 1999, althoughat a rate only about half as fast as before(see Figure 3). Currency values willgradually strengthen back to pre-collapselevels over the five-year forecasthorizon—1998 to 2002.• The slow and uncertain Asian recoverywill be unlike the relatively rapid one inMexico. Japan, the most powerfuleconomy in Asia, has already slippedfrom sluggish growth in 1997 to outrightrecession in 1998, and prospectsfor recovery are weak at best. HongKong has also officially slipped into recession.• The weakening of the U.S. and worldeconomies will drive down domesticdemand for food and fiber. Low inflationwill prevent general cost-push inflationpressure on the U.S. farm sector,and stable-to-declining interest rates willalso prevent a sharp rise in the debtserviceburden.• U.S. and global supplies of major farmcommodities will grow consistent withhistorical trends.China remains a wild card in the outlook forfarm exports. With a population base of 1.2billion (growing at 1.2 percent annually) andwith sustained real per capita economicgrowth of 6 to 8 percent, the potential forincreased food demand is indeed huge — inthe range of 4 to 5 percent annual real growth.We expect China’s domestic food productionto lag behind growth in demand andcause China to keep importing vast amountsfrom the world market.Should the Asian economic flu spread toChina, however, the nation would be forcedinto a round of competitive currency devaluations.China’s economic growth would slowdramatically and the U.S. would lose anotherstrong growth market for farm exports. Thisis an important downside risk to the forecast.With high crop production expected againin 1998, stocks will continue the rebuildingbegun in 1997, which combined with weakglobal demand will put more downwardpressure on prices. Due to the high percentageexported, wheat is the commodity mostat risk of facing chronic surpluses and lowprices. A glut of hogs has prevented cattleprices from gaining as much as expectedduring this rebuilding phase of the cattlecycle.Continued Asia DepressionScenario AssumptionsThere is a downside risk that the Asian economicdepression will be deeper, more widespread,and longer than assumed in theBaseline Scenario. In the Continued AsianDepression Scenario, independent variablesexcept for lower economic growth in SoutheastAsia were held at the levels of the BaselineScenario. The result is a forecast with “allother things being equal.” We make the followingassumptions about economic conditionsin Asia:The Continued Asian Depression Scenariowould reduce annual Gross Domestic Product(GDP) growth in that region by 5 fullpercentage points below the 1998 BaselineScenario (which itself was already well belowthe assumptions in the 1997 Baseline).The hardest-hit economies of Southeast Asiawill remain at depressed levels of economicactivity, experiencing –10 percent growth inreal GDP in 1998, –5 percent in 1999, and anaverage of -2 percent from 2000 to 2002.• Japan enters recession in 1998, then resumesa sluggish growth path in 1999, averagingonly 2 percent annual growth inreal GDP.

FCA 1998Mid-Year Report41• Economic growth in China slows to 6 percentin 1998 and averages only 3 percentfrom 1999 to 2002.• Asian currencies hold at current levelsagainst the U.S. dollar from 1999 to 2002.Declining Rates of ForeignExchangeThe model does not account for the additionalnegative effect of the collapsing currenciesin Southeast Asia. Thus, the actualimpact on export demand will be more severethan in either of the scenarios depictedhere, as the collapse of currencies in SoutheastAsian countries has been nothing shortof spectacular. Between December 1996 andDecember 1997 the currency of Indonesiawas down 51.6 percent against the U.S. dollar,doubling the price of U.S. farm importsinto Indonesia. The currency situation wasnearly as bad elsewhere against the U.S. dollar:Korea was down 43.5 percent; Thailand43.6 percent; Malaysia 33.0 percent; the Philippines29.3 percent; Taiwan 15.3 percent, andSingapore was down 15 percent. In spite ofthe best efforts of the IMF, these currenciescontinued to depreciate during the first halfof 1998.The U.S. dollar also has risen appreciablyagainst the currencies of our major competitorsamong exporting nations. Over the pastyear (July 1997 to July 1998), the U.S. dollaris up 20 percent against Australia and 8 percentagainst Canada, the United States’ twomost important competitors in the worldwheat market. Similarly, the dollar is up 37percent against South Africa, a major competitorin the world corn market; 19 percentagainst India, a major competitor in the worldcotton market, and 11 percent against Brazil,a major competitor in the world soybeanmarket.A movement in foreign exchange rates isequivalent to a change in domestic prices.For example, if the value of the dollar rises50 percent against a foreign currency, theprice of U.S. farm products measured in unitsof that currency rises 50 percent, which depressesthe quantity demanded even if U.S.domestic prices remain constant. Empiricalresearch shows that farm exports are lesssensitive to changes in exchange rates thanare general merchandise exports, but they doreact, and with about the same two- to threeyeartime lag. This suggests that the currentlevels of exchange rates will depress U.S. farmexports below what they would otherwisehave been for the next two to three years,considering what already has happened, evenif foreign currencies recover some of theirprevious value against the U.S. dollar.Among exports of bulk agricultural commodities,soybeans are the most sensitive tochanges in exchange rates and wheat is theleast sensitive. Economic theory predicts thatthe closer a market is to free competition,the more responsive demand will be tochanges in prices and exchange rates. Internationaltrade in soybeans is much closer tothe free market model, while the wheat tradeis highly subsidized and regulated by governments.In addition to the foreign exchange rate effect,a spillover of the Asian economic crisismay reduce world GDP by perhaps 0.5 to 1percent from what it otherwise would havebeen. We did not simulate this effect; theresults reported here would likely be muchworse if the effects of both currency devaluationsand diminished world GDP growthwere considered.Finally, research shows that on average farmreal estate assets take six years to fully adjustto changes in capitalized farm income.Sometimes it has taken longer, sometimesshorter. In this model, we forced the adjustmentto occur over a three-year period forthe purposes of simulating a worst-case scenariofor land values.

FCA 1998Mid-Year Report42Forecast Results Under the TwoAlternative ScenariosEconomic conditions in the U.S. farm sectorin 1998 are considerably weaker than in 1997,when net farm income fell to $49.9 billionfrom $53.5 billion in 1996. Net farm incomeis expected to fall again to $42.5 billion in1998—a 20 percent decline from the 1996peak. Under the Baseline Scenario, 1999 netfarm income is forecast to rise a bit to $45.6billion, but will remain below $50 billionthrough the year 2002 (see Figure 4). Overthe next five years (1998-2002) net farm incomewill average about $1 billion less thanover the last five years. However, net incomeunder the Continued Asian Depression Scenariowould average about $2 billion lowerthan under the Baseline Scenario during thenext five years.The farm sector balance sheet continued tostrengthen in 1997, but gains will be limitedfrom 1998 to 2002. Farm asset values haverisen for 11 years in a row, driven largely bygains in farm real estate, which averaged 6percent annually from 1993 through 1997.The Baseline forecast shows gains in realestate assets slowing to 2.6 percent in 1998after 5.8 percent growth in 1997. Real estatevalues are forecast to fall in 1999 by 0.6 percentand remain weak through the year 2002(see Figure 5). The annual average gain infarmland values over the next five years willbe less than 1 percent, down from 6 percentduring the previous five years. In the DepressionScenario, real estate values willslowly decline by about 3 percent over theforecast period.Total farm debt increased 3.4 percent in 1996and 3.8 percent in 1997. We expect total debtto rise just 1.9 percent in 1998 and 1.8 percentin 1999 (Baseline Scenario). Then, farmdebt is forecast to be nearly stagnant throughthe year 2002 (see Figure 6). While farmers’debt-carrying capacity will still be large andnot entirely used, weak financial conditionswill make farmers even more debt-averse.Average annual gains in farm debt over thenext five years will be around 1 percent (andwill be zero under the Depression Scenario),down from 3 percent during the previousfive years. Even in the Baseline Scenario wewould expect that, given the weak financialconditions, the quality of farm debt woulddeteriorate—but more so in the DepressionScenario.Figure 4Impact of S.E. Asian Crisis on Net Farm Income$ Billions

FCA 1998Mid-Year Report43Figure 5Impact of S.E. Asian Crisis on Total Value of Farm Real Estate$ BillionsFigure 6Impact of S.E. Asian Crisis on Total Farm Debt$ BillionsNote: Farm Debt of $162 billion for 1997 is reported in USDA’s August 1998 Agricultural Outlook. However, new datasuggest that farm debt in 1997 and 1998 will be about $3-$4 billion higher than reported here.

FCA 1998Mid-Year Report44Impact on the Farm Economy byFarm Credit DistrictDue to the different commodity concentrationsin each of the seven Farm Credit SystemDistricts, the effect of the ContinuedAsian Depression Scenario (as comparedwith the 1998 Baseline) is different for eachdistrict. Figures 7 and 8 illustrate the averagepercentage effect on annual net farmincome and farm real estate assets for eachdistrict over the 1998 to 2002 period.Recall that the 1998 Baseline Scenario alreadyaccounts for the current collapse of theSoutheast Asian economies. The effect ofthe collapse itself compared with the old 1997Baseline, which showed continued strongeconomic growth in Asia, cannot be measureddirectly because the current version ofthe model was not available on a districtlevelbasis in 1997.Figure 7Net Farm Income: Depression Scenario Comparedwith 1998 Baseline, by DistrictPercentPercentages represent annual averages for 1998-2002 period.Because commodity concentrations vary by district, the impact of the S.E. Asian crisis will be different according to themajor exports of the region. Result is understated in heavy areas of fruit, vegetable, or nut production - Western,CoBank, and Ag First.

FCA 1998Mid-Year Report45Figure 8Farm Real Estate Assets: Depression Scenario Compared with 1998Baseline, by DistrictPercentPercentages represent annual averages for 1998-2002 period.Commodity concentrations vary by district, the impact of the S.E. Asian crisis will be different according to the majorexports of the region.How Will Commodity Prices Be Affected?Under the 1998 Baseline, most commodity prices (prices for steers, broilers, and milk areexceptions) will average much lower for the next five years than for the previous five years, asfollows:Commodity Avg. Price last 5 yrs Avg. Price next 5 yrs Avg. ChangeCorn $2.63/bu $2.22/bu Decline $0.41/buWheat 3.79/bu 3.33/bu Decline .46/buSoybeans 6.48/bu 5.43/bu Decline 1.05/buCotton 67.98/lb 66.00/lb Decline 1.98/lbSteers 68.59/cwt 73.9/cwt Rise 5.31/cwtHogs 46.65/cwt 42.6/cwt Decline 4.05/cwtBroilers 57.46/lb 57.8/lb Rise .34/lbMilk 13.32/cwt 13.66/cwt Rise .34/cwt

FCA 1998Mid-Year Report46Growth in real GDP in Southeast Asia createsgrowth in demand for U.S. farm exports,which in turn creates growth in farm prices.Similarly, declines in GDP create decliningexport demand and declining prices. A usefultool for measuring the degree of changeis “elasticity,” which measures the percentchange in a variable that results from a percentchange in another variable.For example, in the model we estimate thatfor corn, a 1 percent change in SoutheastAsian GDP creates a 2 percent change in U.S.farm prices. Thus, if a scenario indicated a5 percent difference in Southeast Asian GDP,there would be a 10 percent difference in U.S.corn prices.The following summary table lists the effecton prices of a 1 and a 5 percent decline inSoutheast Asian GDP growth. Recall thatthe difference between the 1998 BaselineScenario and the Continued Asian DepressionScenario represents a difference of 5percentage points of growth, so that for theContinued Asian Depression effect the elasticitiesare multiplied by a factor of 5. Wethen calculate the dollar value of the per-unitprice change for each commodity under theContinued Asian Depression Scenario. Wehave listed the commodities in decliningorder of change in the table so that analystscan easily see which commodities are mostat risk and can use the relationship to calculatetheir own price changes, given differingassumptions about changes in gross domesticproducts in Southeast Asia while othervariables remain equal.The table shows that when comparing theBaseline Scenario with the Continued DepressionScenario, cotton and broiler priceswould be affected the most in percentageterms — that is, their elasticities are higher.Specifically, cotton prices would average 11.9cents per pound below the already-reduced1998 Baseline levels. Wheat prices would beaffected the least and would average 15 centsper bushel below the already-reduced 1998Baseline levels.Vulnerability of Commodity Prices to Changesin Southeast Asian Growth Rates(Change in prices in final column can be viewed as the effect of the Depression compared with theBaseline Scenario)Unit Price Change Resulting from1 Percent change in 5 Percent change in Asian Depression—SE Asia GDP SE Asia GDP change from BaselineCotton Price 3.6% 18.0% –11.88 cents per poundBroiler Price 3.4% 17.0% –9.83 cents per poundSoybean Price 2.2% 11.0% –$0.60 per bushelCorn Price 2.0% 10.0% –$0.22 per bushelRice Price 2.0% 10.0% –$0.88 per hundredweightCattle Price 1.4% 7.0% –$5.17 per hundredweightHog Price 1.3% 6.5% –$2.77 per hundredweightWheat Price 0.9% 4.5% –$0.15 per bushel

FCA 1998Mid-Year Report47ConclusionsChallenges for the Farm Credit System include managing lending risk to farmers facing greaterprice and income risk from the marketplace, without Government price protection. A newrisk—weak commodity markets—could coincide with the elimination of farm programpayments after 2002. Without renewed Government income supports, farmland values willexperience a further decline. Even with the current level of guaranteed payments the updatedFarm Sector Economics forecast shows a slight decline in real estate markets in 1999, withrelatively stagnant asset and debt markets through the year 2002. The national totals forecastin this article mask the more serious income declines that will be experienced by some. Thoseproducers heavily dependent on the commodities most affected by the declines in exportdemand will experience serious financial stress if market supplies do not adjust to the realityof lower worldwide demand. Clearly, lenders will have to be very cautious in making assumptionsabout price projections when reviewing debt repayment capacity.Opportunities for the Farm Credit System are less apparent with this update, as most of therisks are now on the downside. However, the Asian economies could recover faster thanprojected, which would lead to stronger-than-forecast export markets for major grains, oilseeds,and livestock. This recovery would capitalize into higher real estate values and strengthenthe demand for farm debt—particularly real estate debt. Under this scenario, demand fornon-real estate debt would also expand significantly.

FCA 1998Mid-Year Report48Farm Credit AdministrationFiscal Year 1999 RegulatoryPerformance PlanApproved by the Board September 23, 1998The Farm Credit Administration adopts andissues policy statements and regulations tohelp ensure that the Farm Credit Systemcomplies with the law and operates in a safeand sound manner. As the independentregulator of the System, the FCA is responsiblefor protecting the public’s interest. Accordingly,the FCA Board strives to adoptsound and constructive policies and regulations,take a proactive and preventive approach,and reflect the changing needs of agriculture.The FCA anticipates another active regulatoryperiod during fiscal year 1999. The attachedFiscal Year 1999 Regulatory PerformancePlan (Plan) includes the regulatoryprojects proposed for completion in fiscalyear 1999. The Agency also plans to conducta complete review of all current regulationsto identify any areas where more flexibilitycan allow System institutions to adjust theirstructures and lending authorities within theFarm Credit Act of 1971, as amended. Thisreview may provide new priorities for thePlan and may require the Agency to reassessits current projects for fiscal year 1999. Inaddition, the Regulatory Burden notice maygenerate comments and create the need fornew regulation projects not currently listedin the Plan.describes the changes being considered andtells the public how they may participate inthe rulemaking process. A final rule establishesthe basis and purpose for the regulatoryrevisions or additions that are beingadopted by an agency. The final rule willadvise interested parties how the rule will beapplied, respond to questions and issuesraised during the rulemaking, and serve as areference for the future.Since 1997 we have provided the public witheasy access to FCA regulations through ourinteractive Website. The Agency’s goal isto foster a more interactive relationship andencourage public participation in therulemaking process. The public is invitedto submit comments on individual rulemakingprojects via electronic mail toreg-comm@fca.gov or through the PendingRegulations section of the FCA’s interactiveWebsite at www.fca.gov.As is customary, the Plan details two typesof regulatory actions for fiscal year 1999:proposed rules and final rules. The purposeof a proposed rule is to notify the public ofan agency’s intent to revise existing regulationsor create new ones. The proposed rule

FCA 1998Mid-Year Report49Regulation ProjectAction Date Type of Action Brief Project DescriptionOctober – December 1998Customer Choice Proposed Rule Provide additional flexibility for borrowers to obtain financingand other financial services from System institutions of theirchoice and reduce regulatory burdenBalloting and Stockholder Reconsideration Issues Final Rule Address regulatory burden issues concerning balloting and voterreconsideration when System institutions engage in corporaterestructuringJanuary – March 1999Farm Credit Bank Assistance to Associations Proposed Rule Clarify when Agency consent is needed for approval of financialassistance provided to associations by Farm Credit banksFAMC Risk-Based Capital Proposed Rule Office of Secondary Market Oversight will make a rule to establisha risk-based capital requirement for Farmer MacRelease of Information Proposed Rule Conform FCA regulations to Department of Justice guidanceand clarify procedures for processing requests for exempt informationFCS Board Compensation Limits Final Rule Remove Agency prior approval for certain instances in whichbank director compensation can exceed the adjusted maximumApril – June 1999Investment Management Final Rule Clarify current investment management regulations with respectto safety and soundness and in response to petitions received toamend the regulations. Provide guidance consistent with otherfinancial institution regulatorsRegulatory Burden Phase I Action Address comments received from the Regulatory Burden Noticepublished in August 1998Leasing Authorities Final Rule Issue comprehensive leasing regulations for all System institutionsJuly – September 1999Comprehensive Borrower Rights Proposed Rule Revise the borrower rights regulations to provide clarificationand remove unnecessary burdensTermination Regulations Proposed Rule Establish regulations under which a bank or large associationwithin the System can terminate its charter as provided for inthe Farm Credit Act of 1971, as amendedFarm Credit Bank Assistance to Associations Final Rule Clarify when Agency consent is needed for approval of financialassistance provided to associations by Farm Credit banksPotential Competition Philosophy ProjectsCompetition Philosophy Projects TBD Projects resulting from the FCA Board Philosophy Statementon Competition to provide a regulatory environment that willafford System institutions greater flexibility to adjust their structuresand lending authorities within the Farm Credit Act of1971, as amendedIf there are questions on the Fiscal Year 1999 Regulatory Performance Plan, please contact Patricia W. DiMuzio, Director,Regulation and Policy Division, Office of Policy and Analysis, at (703) 883-4498.

FCA 1998Mid-Year Report50Farm Credit Administration’s LoanPortfolio Management SymposiumMajor changes in the marketplace and ingovernment policies are bringing more riskto the agricultural lending environment. Increasingly,the agricultural industry relies onuncertain foreign markets to maintain itseconomic vitality. At the same time, the FederalAgriculture Improvement and ReformAct of 1996 (FAIR), by reducing the safetynet that many farmers relied on for decades,has shifted the risk management burden toproducers and farm lenders.These risks have become reality in 1998, ayear of low market prices for many commodities.Supplies have been abundant, andexport demand has been reduced because ofthe financial crisis in Asia. Before this crisis,Asia was regarded as an important source ofgrowth in agricultural export demand. Nowthat source of demand growth is in seriousdoubt. And although farmers are receivingfixed transition payments as provided by theFAIR Act, those payments are lower than theywould have been under previous farm legislation.Farm Credit System (FCS) institutions werecreated to provide loans to agriculture ingood times and bad. The inherent risk ofagricultural lending and the statutory limitationson lending authority, which result inadditional risk from credit concentrations inthe FCS, make effective management of loanportfolios essential. Furthermore, a rapidlychanging and competitive lending environmentdictates that FCS institutions managetheir loan portfolios proactively and strategically.Consequently, loan portfolio managementhas become more important than everfor Farm Credit institutions.Indeed, competition is characteristic of thefarm lending market. FCS institutions arecompeting for the very best credit customerswith commercial banks and insurancecompanies, as well as nonbank lenders likeJohn Deere Credit, Pioneer HiBred, G.E.Capital Mortgage Services, and a host ofothers. If this were not enough, cyber bankingover the Internet may also develop intoa real competitive force over time. This isnot a time for successful farm lenders to reston their laurels.The FCA is pleased to sponsor a symposiumthat will highlight some of the more criticaland timely issues related to loan portfoliomanagement. The symposium will providea forum for discussing these issues with FarmCredit colleagues and an impressive groupof expert speakers from around the country.Discussions of state-of-the-art issues in managementinformation systems, portfolio stresstesting, environmental risk evaluation, andother key topics make this symposium amust for proactive Farm Credit leaders.The symposium is structured for Systempersonnel, primarily System CEOs, chiefcredit officers, and others involved in thecredit function. The Symposium will be heldDecember 6-8, 1998 at the Fairview ParkMarriott Hotel in Falls Church, Va.For registration materials for the Loan PortfolioManagement Symposium, call the Officeof Congressional and Public Affairs at(703) 883-4056.

SymposiumProgramFCA 1998Mid-Year ReportSunday, December 65:00- 9:00 p.m.Check-in and receptionMonday, December 77:45 a.m. ContinentalBreakfast/RegistrationMaster of CeremoniesDavid Kohl, Professor ofAgricultural Finance,Virginia Tech8:30 a.m. WelcomeMarsha Martin,Chairman and CEO, FCAThomas McKenzie,Director, Office of Policy andAnalysis, FCAFuture of Agricultural Lending,Emerging TrendsMichael Boehlje,Professor of Agribusiness,Purdue UniversityLoan Portfolio Management inCommercial BankingJohn Barrickman,President,New Horizons Financial GroupManagement InformationSystems for the FCSVictor Dupuy,Senior Manager,KPMG Peat Marwick12:30 p.m. Lunch(Monday, December 7 cont.)1:45 p.m. Breakout Sessions 1Stress Testing Your FarmLoan PortfolioJoe Davis, President,AgriLogic, Inc.Credit Rating SystemsJohn Barrickman, President,New Horizons Financial GroupRisk DiversificationRobert Bonnet, Chief,Guaranteed Loan Making, FarmService Agency andTom Clark, Vice President,Corporate Relations, Farmer MacLender Liability andEnvironmental RiskRandy Muller, Vice President,Environmental Services,Bank of America3:00 p.m. Breakout Sessions 2Stress Testing Your FarmLoan PortfolioCredit Rating SystemsRisk DiversificationLender Liability andEnvironmental Risk5:00 p.m. Social Hour6:15 p.m. DinnerSpeaker to be announcedTuesday, December 88:00 a.m.Continental BreakfastPanel on FCS PortfolioManagement SystemsPaul DeBriyn, President and CEO,AgStar ACAAndy Lowrey, President and CEO,AgFirst FCBJay Penick, President and CEO,Northwest ACACollateral Risk – Have YouFactored It Into YourPortfolio?Art Clapp, President-Elect,American Society of FarmManagers and Rural AppraisersThe Role of Marketing inPortfolio ManagementJim McComb, Senior Consultant,Farm Credit CouncilServices, Inc.12:00 p.m. Lunch“The Future of U.S. FarmPolicy”Kika de la Garza,former Chairman of the HouseAgriculture CommitteeInternal Controls and LoanUnderwritingCarl Premschak,Senior Examiner, FCAWrap-up and SummaryRoland Smith,Chief Examiner, FCA2:00 p.m. Adjourn

FCA 1998Mid-Year Report52Corporate Restructuring of Farm CreditSystem InstitutionsElna LuopaOverviewThe number of Farm Credit System institutions,including service corporations, declinedfrom 222 on October 1, 1997, to 208by October 1, 1998. The most significantdecline was in the number of Federal LandBank Associations (FLBAs), from 51 to 40 inone year, as a result of mergers in the TexasDistrict and formations of direct lender FederalLand Credit Associations (FLCAs), in theWichita District. FLBAs affiliated with theFarm Credit Bank of Texas are also expectedto begin the transition to FLCAs by mid-1999 provided the bank’s stockholders approvea proposed plan to transfer direct lendingauthority. In April 1998, voting stockholdersof the Farm Credit Bank of Wichitaapproved a plan to transfer direct lendingauthority to FLBAs in that district and, as ofOctober 1, two FLCAs are now operatingwithin the district. Mergers between AgriculturalCredit Associations (ACAs) are alsocontinuing, and over the past year the numberof ACAs has declined by 3 to 57.Through October 1, 1998, the Farm CreditAdministration (FCA) Board approved 16corporate applications that have become effectivesince January 1. These approvals includea plan from a Farm Credit Bank totransfer direct lending authority to eligibleFLBAs ; approvals to form two FLCAs; eightassociation mergers; one change to anassociation’s chartered territory; the voluntaryliquidation of a service corporation;amendments that modified the Articles ofIncorporation of a service corporation; oneassociation headquarters relocation; and oneassociation name change. Of the eight mergers,three occurred in the AgriBank, FCB District,four in the Farm Credit Bank of TexasDistrict, and one in the AgFirst Farm CreditBank District. This corporate activity is detailedin Table 1. (See the Report on the FinancialCondition and Performance of theFarm Credit System 1997 for corporate activityin 1997 through January 1, 1998).Wichita RestructuringOn March 10, 1998, the FCA Board approvedthe plan submitted by the Farm Credit Bankof Wichita to transfer direct lending authorityto all eligible FLBAs within the District(Colorado, Kansas, New Mexico, Oklahoma)provided that the FLBAs obtain approvalfrom the FCA to operate as FLCAs within atwo-year window beginning July 1, 1998. TheFarm Credit Services of Central Kansas,FLBA, and Farm Credit Services of NortheastKansas, FLBA, obtained charters to operateas FLCAs effective July 1, 1998, andOctober 1, 1998, respectively.Texas RestructuringA similar plan to transfer direct lending authorityfrom the Farm Credit Bank of Texas(FCBT) to its eligible FLBAs was given preliminaryapproval by the FCA Board on September21, 1998. The plan must also be approvedby a majority of the voting stockholdersof the FCBT before it can be implemented.The district would then have a twoyearwindow during which individual FLBAstockholders must approve the plan for theirrespective FLBA before the Agency issues anFLCA charter. Twenty FLBAs originate mortgageloans for the FCBT in Texas, Alabama,Louisiana and Mississippi.Liquidation of AgCo ServicesCorporationThe Board also approved a plan of voluntaryliquidation of AgCo Services Corporation(AgCo), a wholly owned subsidiary ofCoBank, ACB. Under the plan, CoBankagreed to assume all remaining liabilities ofAgCo. The FCA Board cancelled AgCo’scharter effective at the close of business onJuly 22, 1998. Notice of the FCA Board’sactions with respect to AgCo were publishedin the July 27, 1998, Federal Register at 63 FR40123.

FCA 1998Mid-Year Report53Other FCA Board ActionsSince January 1, 1998, the FCA Board hasgranted preliminary approval to a merger oftwo ACAs affiliated with AgriBank, FCB, andthe formation of a third FLCA in territorychartered to the Farm Credit Bank ofWichita. Agency final approval of these actionsis subject to approval by the votingstockholders of the associations involved.Pending ApplicationsAs of October 1, 1998, the following applicationsare pending FCA Board consideration:(1) a merger of two Production Credit Associations(PCAs) in the Texas District; (2) twoconsolidations involving five ACAs in theAgFirst District; and (3) expansion of territoryrequests filed by two groups of jointlymanaged PCAs and FLCAs; and (4) a namechange request. Action by the FCA Boardon an earlier request—to establish a servicecorporation—filed by a PCA affiliated withthe FCB of Texas—continues to be deferreduntil further information is provided to theAgency.FCA Board Philosophy Statementon Intra-System CompetitionOn July 14, 1998, the FCA Board adopted astatement outlining its philosophy that “. . .unrestricted intra-System competition isbeneficial for the customer and the long-termrelevancy of the Farm Credit System.” Inthis regard, the FCA Board supports thesepractices:• flexibility for associations to choose theirsource of funding• System initiatives to allow institutionsto become more efficient and relevantin the marketplace• removal of geographic boundaries ofSystem entities• movement toward structures that havebroad-based lending authorities encompassingTitles I, II and III of the Act• broad interpretation of existing statutesto enable System institutions to becomemore competitive and, in the absenceof statutory authority, consideration oflegislative solutions.Table 2 illustrates the bank and associationstructure in each Farm Credit district. Table3 shows 5-year changes in the numbers ofbanks and associations Systemwide. Figure1 depicts the chartered territories of FarmCredit System banks.Since its 1916 inception, the Farm CreditSystem has evolved with economic and politicalchanges. It underwent many structuralchanges during the 1980’s and early 1990’s, aperiod of financial crisis and major restructuringwithin American agriculture. TheSystem has recovered from its financial crisisand is, once again, a fully viable lender toagriculture. Nevertheless, the FCA Boardbelieves that if the System is to remain relevantas a financial service provider in thecoming century, the System must adapt tonew challenges. As the regulatory environmentand markets change and as other financialservice providers reach to reinventthe future, System institutions face the needto change strategically to retain and betterserve their customers.

FCA 1998Mid-Year Report54Table 1Farm Credit Administration Corporate Activity January 2, 1998 through October 1, 1998Effective DateCorporate ActivityAffiliated Bank andInstitutionChartered Name ofResulting InstitutionHeadquarters Location10/1/98 Merger FCB of Texas Heritage Land Bank, FLBA Tyler, Smith County, TX·FLBA of Tyler·FLBA of McKinney(continuing FLBA)10/1/98 FLCA Charter FCB of Wichita Farm Credit Services of Manhattan, Riley County, KS·Farm Credit Services of Northeast Kansas, FLCANortheast Kansas, FLBA9/15/98 Headquarters Relocation FCB of Texas No change Weatherford, Parker County, TX·Lone Star FLBA9/1/98 Merger FCB of Texas·FLBA of Hillsboro FLBA of Waco Waco, McLennan County, TX·FLBA of Waco (continuing FLBA)8/1/98 Merger FCB of Texas Southeast Texas Bryan, Brazos County, TX·FLBA of DaytonFederal Land Bank Association·FLBA of Edna·LaGrange-Bellville FLBA of Bellville·FLBA of Bryan (continuing FLBA)7/22/98 Voluntary Liquidation CoBank, ACB Charter cancelled at the close of Denver, CO·AgCo Services Corporation business on 7/22/98 uponcompletion of voluntary liquidation7/1/98 Merger AgriBank, FCB Badgerland Farm Baraboo, Sauk County, WI(cob 6/30) ·Harvestland Farm Credit Services, FLCACredit Services, FLCA·Badgerland Farm CreditServices, FLCA(continuing FLCA)7/1/98 Merger AgriBank, FCB Badgerland Farm Baraboo, Sauk County, WI(cob 6/30) ·Harvestland Farm Credit Services, ACACredit Services, ACA·Badgerland FarmCredit Services, ACA(continuing ACA)

FCA 1998Mid-Year Report55Table 1Farm Credit Administration Corporate Activity January 2, 1998 through October 1, 1998Effective DateCorporate ActivityAffiliated Bank andInstitutionChartered Name ofResulting InstitutionHeadquarters Location7/1/98 Merger AgFirst FCB Blue Ridge Staunton, Augusta County, VA·Warrenton Farm Credit, ACA Farm Credit, ACA·Staunton Farm Credit,ACA (continuing ACA)7/1/98 Merger AgriBank, FCB AgStar Farm Mankato, Blue Earth County, MN(cob 6/30) ·Farm Credit Services Credit Services, ACAof St. Cloud, ACA·Farm Credit Services of SouthernMinnesota, ACA (continuing ACA)7/1/98 FLCA Charter FCB of Wichita Farm Credit Services of Wichita, Sedgwick County, KS·Farm Credit Services Central Kansas, FLCAof Central Kansas, FLBA7/1/98 Transfer of Direct Lending FCB of Wichita No change in name. Wichita, KSAuthority to EligibleTwo-year window inDistrict FLBAseffect for transfers,7/1/98-7/1/20005/18/98 Amendment to All Farm Credit banks No change in name. St. Paul, MNArticles of Incorporation ·Farm Credit Leasing Amendments to FCLSC’sServices Corporation Articles eliminate requirementfor election of directors to board.Each bank shareholder willdesignate a director toserve on the board.5/1/98 Charter Amendment AgriBank, FCB Badgerland Farm Fond du Lac,(expansion of territory ·Badgerland Farm Credit Services, FLCA Fond du Lac County, WIto add 6 counties)Credit Services, FLCA5/1/98 Merger FCB of Texas FLBA of Southwest Texas Devine, Medina County, TX·FLBA of Sonora·FLBA of Southwest Texas (continuing)4/1/98 Name Change FCB of Texas PCA of New Mexico Albuquerque,·Albuquerque PCABernalillo County, NMSource: FCA, Office of Policy and Analysis, Risk Analysis Division, records.

FCA 1998Mid-Year Report56Table 2Farm Credit System Banks and Associations 1(As of October 1, 1998)Bank Affiliation PCAs FLBAs ACAs FLCAs ACB FCBs BC TotalCoBank, ACB 2 0 0 4 0 1 0 0 5AgFirst FCB 1 0 38 0 0 1 0 40AgriBank, FCB 18 0 9 18 0 1 0 46FCB of Wichita 18 20 0 2 0 1 0 41FCB of Texas 16 20 0 0 0 1 0 37Western FCB 10 0 5 11 0 1 0 27AgAmerica, FCB 1 0 1 1 0 1 0 4St. Paul BC 3 0 0 0 0 0 0 1 110/1/98 Total 64 40 57 32 1 6 1 20110/1/97 Total 64 51 60 31 1 6 1 214Increase/(Decrease) 0 (11) (3) 1 0 0 0 (13)1. PCA = Production Credit Association; FLBA = Federal Land Bank Association; ACA = Agricultural Credit Association;FLCA = Federal Land Credit Association; ACB = Agricultural Credit Bank; FCB = Farm Credit Bank; BC = Bank forCooperatives.2. CoBank, ACB has authority to serve cooperatives nationwide and ACAs in CoBank’s Northeast Region.3. The St. Paul BC serves cooperatives nationwide.Source: FCA, Office of Policy and Analysis, Risk Analysis Division, records.Table 3Numbers of Farm Credit Banks and Associations by Type 1 , 1994–1998(As of October 1, 1998)Year PCAs FLBAs ACAs FLCAs ACB FCBs BCs Total1998 64 40 57 32 1 6 1 2011997 64 51 60 31 1 6 1 2141996 66 69 60 32 1 6 1 2351995 66 70 60 32 1 7 1 2371994 69 72 66 31 0 9 3 2501. PCA = Production Credit Association; FLBA = Federal Land Bank Association; ACA = Agricultural Credit Association;FLCA = Federal Land Credit Association; ACB = Agricultural Credit Bank; FCB = Farm Credit Bank; BC = Bank forCooperatives.

Figure 1Farm Credit System Banks Chartered Territories(As of October 1, 1998 )FCA 1998Mid-Year Report57Source: FCA, Office of Policy and Analysis, Risk Analysis Division, records.

FCA 1998Mid-Year Report58Major Financial Indicators by System, Quarterly Comparison 1At and For the 3 Months ended(Dollars in Thousands)Farm Credit System Banks 2,9 Jun 30 ‘98 Mar 31 ‘98 Dec 31 ‘97 Sep 30 ‘97 Jun 30 ‘97Gross Loan Volume 60,446,778 58,368,049 58,396,451 58,281,477 57,782,928Formally Restructured Loans 3 280,551 259,935 277,963 316,486 296,403Accrual Loans 90 or More Days Past Due 27,423 27,877 6,311 7,803 11,529Nonaccrual Loans 250,826 246,135 224,793 263,050 567,088Nonperforming Loans 4 0.92% 0.91% 0.87% 1.01% 1.51%Cash and Marketable Investments 12,074,904 11,986,065 12,021,111 11,428,955 11,221,146Total Capital/Total Assets 5 8.47% 8.62% 8.53% 8.60% 8.56%Total URE/Total Assets 4.07% 4.09% 4.03% 4.05% 3.98%Total Net Income 171,353 169,323 188,721 182,601 165,058ROA 6 0.96% 0.98% 1.07% 1.05% 0.96%ROE 6 11.09% 11.22% 12.27% 12.07% 11.15%Net Interest Margin 1.49% 1.51% 1.55% 1.63% 1.55%Operating Expense Rate 7 0.47% 0.48% 0.59% 0.53% 0.52%Associations (excluding FLBAs) 9Gross Loan Volume 38,784,222 36,866,183 36,820,170 36,330,432 35,546,444Formally Restructured Loans 3 68,286 77,017 89,137 76,932 77,216Accrual Loans 90 or More Days Past Due 44,978 37,917 23,086 20,355 31,134Nonaccrual Loans 353,709 366,449 367,066 383,250 398,212Nonperforming Loans 4 1.20% 1.31% 1.30% 1.32% 1.43%Total Capital/Total Assets 5 16.11% 16.57% 16.24% 16.22% 16.36%Total URE/Total Assets 12.47% 12.84% 12.34% 12.49% 12.41%Total Net Income 170,659 200,655 173,054 156,194 151,526ROA 6 1.72% 2.11% 1.77% 1.61% 1.65%ROE 6 10.25% 12.43% 10.57% 9.70% 9.70%Net Interest Margin 3.34% 3.47% 3.37% 3.26% 3.45%Operating Expense Rate 7 1.69% 1.77% 1.97% 1.76% 1.83%Total Farm Credit System 8,10Gross Loan Volume 65,642,000 63,719,000 63,439,000 63,001,000 62,639,000Formally Restructured Loans 3 161,000 176,000 200,000 216,000 220,000Accrual Loans 90 or More Days Past Due 70,000 65,000 36,000 28,000 41,000Nonaccrual Loans 604,000 613,000 592,000 646,000 965,000Nonperforming Loans 4 1.27% 1.34% 1.31% 1.41% 1.96%Total Bonds and Notes 64,415,000 64,415,000 64,479,000 63,964,000 63,362,000Total Capital/Total Assets 5 15.14% 15.10% 14.83% 14.73% 14.54%Total Surplus/Total Assets 10.96% 10.64% 10.56% 10.36% 10.19%Total Net Income 329,000 337,000 332,000 328,000 304,000ROAA 6 1.68% 1.72% 1.66% 1.64% 1.61%ROAE 6 11.25% 11.53% 11.42% 11.36% 11.19%Net Interest Margin 2.92% 2.93% 2.98% 2.99% 2.90%1. Some of the previously published quarterly data have been restated to include subsequent adjustments.2. Includes Farm Credit Banks, the Bank for Cooperatives, and the Agricultural Credit Bank.3. Excludes loans past due 90 days or more.4. Nonperforming Loans are defined as Nonaccural Loans, Formally Restructured Loans, and Accrual Loans 90 or More Days Past Due.5. Total capital includes protected borrower capital.6. Income ratios are annualized.7. Defined as operating expenses divided by average gross loans, annualized.8. Cannot be derived through summation of above categories due to intradistrict and intra-System eliminations.9. Source: FCA Call Reports - Farm Credit Banks and Association Data10. Source: Farm Credit System Reports to Investors

FCA 1998Mid-Year Report59Major Financial Indicators, By District 1, 4At and For the 3 Months Ended 6-30-98(Dollars in Thousands)Farm Credit System Banks Total Gross Nonaccrual Allowance Cash and Capital Earned TotalAssets Loan Loans for Loan Marketable Stock 2 Net NetVolume Losses Investments Worth 3 WorthWichita 5,176,655 4,197,975 51,668 132,941 959,154 344,741 330,269 674,554Texas 4,486,037 3,987,477 35,361 51,847 424,341 99,334 258,075 357,408Western 5,555,701 4,664,498 0 5,000 774,059 204,895 197,021 403,393Agribank 18,606,787 15,179,289 70,743 217,527 3,335,811 567,242 863,465 1,433,077AgAmerica 7,873,833 6,774,787 13,708 35,012 1,005,152 550,038 382,688 932,758AgFirst 10,361,478 8,487,635 0 11,267 1,727,770 308,630 348,880 656,720CoBank 18,701,284 15,152,780 38,084 238,272 3,509,907 858,251 557,925 1,422,178St. Paul BC 2,407,853 2,002,337 41,262 54,071 338,710 281,883 36,951 318,754Total 73,169,628 60,446,778 250,826 745,937 12,074,904 3,215,014 2,975,274 6,198,842Associations (excluding FLBAs)Wichita 964,649 883,294 4,978 27,846 15,890 46,692 160,891 207,818Texas 906,465 842,248 9,375 25,385 4,035 64,130 158,247 222,377Western 5,578,449 5,249,715 39,251 115,929 51,445 132,970 727,820 860,790Agribank 15,239,505 14,337,635 115,497 270,037 55 300,964 1,939,827 2,246,078AgAmerica 7,354,421 6,805,004 79,397 295,506 16,255 67,769 999,630 1,111,241AgFirst 9,214,760 8,821,818 82,710 251,277 4,109 215,913 1,468,359 1,721,426CoBank 1,962,024 1,844,508 22,501 50,140 7,892 50,264 306,487 356,751Total 41,220,273 38,784,222 353,709 1,036,120 99,681 878,702 5,761,261 6,726,481FCS Totals 78,164,000 63,719,000 613,000 1,848,000 12,807,000 1,872,000 8,564,000 11,907,0001. Aggregations of district data may not equal totals due to eliminations.2. Includes protected borrower capital.3. Excludes accumulated other comprehensive income4. Source: FCA Call Reports - Farm Credit Banks and Association Data

FCA 1998Mid-Year Report60GlossaryTerms have the following meanings as usedherein:AACA—Agricultural Credit Association, thesuccessor association resulting from a FederalLand Bank Association/ProductionCredit Association mergerACB—Agricultural Credit Bank, the successorresulting from a Bank for Cooperatives/Farm Credit Bank mergerAgency—Farm Credit AdministrationAssociations—Federal Land Bank Associations,Federal Land Credit Associations, ProductionCredit Associations, and AgriculturalCredit AssociationsBBanks—The Farm Credit Banksbanks—The Farm Credit Banks, the AgriculturalCredit Bank, and (sometimes) theBank for CooperativesBC—Bank for CooperativesConsolidated Bank Debt Securities—debt securitiesissued by a combined Bank grouppursuant to Section 4.2(c) of the Farm CreditActDDL—direct lenderFFarm Credit Act—Farm Credit Act of 1971,as amendedFCA or Agency—Farm Credit AdministrationFCB—Farm Credit BankFCS or System—Farm Credit SystemFLBA—Federal Land Bank AssociationFLCA—Federal Land Credit Association, aFederal Land Bank Association that has beengranted direct lending authorityFunding Corporation—Federal Farm CreditBanks Funding CorporationGGSE—government-sponsored enterpriseInsurance Corporation—Farm Credit SystemInsurance CorporationInsurance Fund—Farm Credit InsuranceFund, maintained by the Insurance Corporationpursuant to the Farm Credit ActOOPA—Office of Policy and AnalysisPPCA—Production Credit AssociationRRCD—Risk Control DivisionROAA—return on average assetsROAE—return on average equitySSystem—the Farm Credit SystemSystemwide Debt Securities—Federal FarmCredit Banks Consolidated SystemwideBonds, Federal Farm Credit Banks ConsolidatedSystemwide Medium-Term Notes, FederalFarm Credit Banks ConsolidatedSystemwide Discount Notes, and any otherdebt securities that may be issued by theBanks pursuant to Section 4.2 (d) of theFarm Credit ActUURE—unallocated retained earningsUSDA—U.S. Department of Agriculture

FCA 1998Mid-Year Report