EFFECTS OF VARIABLE AMORTIZATION PLANS ON BORROWER AND LENDER RISK: A SIMULATION STUDY OF LOW EQUITY ILLINOIS CASH GRAIN FARMS

This study evaluates problems associated with servicing fixed long term debt commitments from variable annual cash flows. Traditional real estate debt contracts typically specify a fixed periodic repayment schedule. The hypothesis tested here is that variable amortization plans (VAPs) can result in reduced lender and borrower risk in agricultural lending where risks arise from varying farm commodity prices and yields. VAPs vary the contractual periodic debt servicing commitment on long term debt in response to varying periodic debt servicing capacity of the borrower. Thus, in years of below (above) average returns from farm production, the required debt servicing payment from current cash flow is correspondingly reduced (increased) with part or all of the long term debt servicing commitment taken from a debt reserve account. The debt reserve account functions as a reservior and is augmented by contributions from current cash flow in years of above average returns.;A dynamic simulation model of a low equity Illinois cash grain farm (a firm liquidity model) was developed to test the hypothesis and meet the study's objectives. This model employed a data sample taken from Farmers Home Administration (FmHA) borrowers to characterize the physical and financial status of a representative farm at the beginning of a ten year test period. This sample consisted of individuals who had received a FmHA "farm ownership" (real estate) loan. This choice of data base was made to reflect a source of "risky" borrowers.;The model encompassed all production, marketing, tax-paying, consumption, investment and financing activities of the representative farm. Finally, the model emphasizes a cash flow concept with special emphasis on debt servicing, financing and refinancing. Resources available for servicing total debt include current period cash flow after tax paying and consumption, current assets, reserved (unused) credit and reserved cash. Lender criteria specified in the model are based on the borrower's leverage ratio and expected debt servicing ability. Variability of annual cash flows and hence, variability of debt servicing capacity occurred through stochastically generated commodity prices and yields.;The model outcomes indicated that the VAP, relative to the TAP, contributed to the stability of "family consumption expenditures," "gross investment expenditures" and "cash income after taxes and consumption." The VAP also exerted a relatively greater stabilizing effect as variability of annual cash flows increased.;This study tests the effectiveness of a VAP in reducing lender risk under alternative scenarios and compares effects of a VAP to those of a traditional amortization plan (TAP) in an environment characterized by high default rates. Lender risk is defined as the probability of default by farm real estate borrowers. In addition, the study evaluates effects of a VAP on selected farm financial characteristics (e.g., leverage ratio, current ratio, net worth and firm growth) and also evaluates selected stability measures (e.g., consumption expenditures, gross investment expenditures and cash income after taxes and consumption) over the test period.;The VAP tended to yield lower probabilities of default than the TAP. As the cash flow variability was increased by varying model parameters, the relative performance of the VAP improved. The VAP never generated higher probability of default than the TAP.;For other performance measures such as firm growth, current ratio, leverage ratio and level of default, the VAP provided superior results. Finally, for risky borrowers, the VAP was found to be an efficient means of providing much needed liquidity.