Analysis of factors influencing loan losses of production credit associations
Authors:   , Samman Musa Ahmad 
Published: May 2024

The Production Credit Associations' loan loss rates and amounts have increased in recent years. Lenders take a certain "calculated" risk in granting, extending additional credit or renewing a loan. Loan risks arise from loan defaults and consequent loan losses. Loan risks cannot be avoided due to lack of sufficient information to appraise the credit-worthiness of loan applicants, lack of sound lending and collection policies as well as due to adverse unforeseen circumstances that arise after the loan has been granted. This study dealt with a retrospective (ex-post) investigation of a sample of (PCA) accounts who defaulted on their loans and their farm businesses were liquidated. The purpose of the investigation was to predict the degree of credit-riskiness (in terms of loan losses) from some measured proxy variables for the borrower's managerial efficiency, character and risk attitude, his farm business income capacity and riskiness, his financial performance as well as the lender's (PCA) loan management policies. Since the explanatory variables were mostly categorical with high intercorrelations, interactions and unbalanced distribution, the general linear model for categorical variables was found to be the appropriate statistical technique. Two models, one for absolute loan losses and the other for relative loan losses, were developed. The criteria for including an independent variable in the final model were: (1) significant at 10 percent of probability and (2) meaningful or could be interpreted within the theoretical framework of the model (attributes of character, economic capacity, riskiness and lending policy). The final models had maximum R^2 to expose all the possible interrelationships among the variables of the study. When the theory of the underlying causal mechanisms and the measurement of the variables become well-developed or understood, simpler models could be substituted. The regression equation for the first model explained about 71 percent of the variation in the absolute loan losses. The explanatory variables for the model in the order of importance (partial R^2) were: PCA commitment representing size of the loan (and the farm business), land tenure reflecting income capacity and loan security, kind of enterprise reflecting the production and market factors and associated risks, outside business interests that interacted with the kind of enterprise to produce a differential effect on loan losses, and finally, the interaction between education and farming experience as a proxy variable for managerial ability, "character" and attitude towards risk. The purpose of the model for relative loan losses, besides its usefulness as a measure of the efficiency of loan recovery, was to reduce the dominant effect of PCA commitment on loan losses so that the importance of other explanatory variables could be revealed. The regression equation explained about 61 percent of the variation in relative loan losses. Additional explanatory variables that were statistically significant were: Farm Credit District reflecting administrative and geographical effect, type of farm operator representing various farm business organizations and four financial ratios reflecting repayment performance, collateral coverage, extent of obligations to outside creditors and solvency. Subject to the conceptual, methodological and data problems encountered, certain lenders' policies and borrowers' characteristics were found to be associated with greater loan losses (absolute or relative). Those lenders' policies were the following: (1) overlending those borrowers with larger scale of operations, capital and total debts; (2) too low or too excessive collateral on the loan (excessive coverage of the loan by collateral may be reflecting lenders' attempt to compensate for already poor credit risk); (3) lower ratio of PCA debt to total debts indicating greater obligations to other creditors or lower ratio of non-real Estate debt to total debts; (4) low ratio of repayment received to repayment schedule; (5) farm credit districts of Louisville, St. Paul and Spokane; and (6) inadequate borrower financial records and inadequate verification of financial statements. Borrower characteristics associated with greater loan losses were: (1) college graduates with high level of farming experience; (2) poultry broilers, poultry layers, fruits and some specialized enterprises (the first two enterprises resulted in higher losses when the borrower did not have outside business interests to supplement his income, while the latter two enterprises had the opposite relation); (3) too low or too high land ownership (the association of too high land ownership-- 1,000 acres or more-- with exceptionally high loan losses may be due to excessive diseconomies of scale); (4) part-time farm operators and non-family corporations; and (5) too low or too excessive ratio of net worth to total debts (the excessive ratio might be due to false financial reporting or extreme aversion to risk).