With U.S. crop prices soaring to historic levels, times are seemingly good for grain farmers and agribusiness firms. So why are lenders worried about the U.S. farm economy?

Despite the trappings of a golden age of agriculture, bankers and regulators are nervously watching two pressure points in farm finance -- grain marketing and soaring farmland prices -- in hopes that a rural credit crunch does not take root.

Ironically, high grain prices could be bad for farmers in at least one way. The recent doubling or tripling of grain prices from historical norms has thrown a wrench into a century-old system that farmers have used for selling grain and financing their production.

As long as this price keeps trending up, the credit outstanding is enormous, said economist Mike Swanson at Wells Fargo, the largest private bank lender to U.S. agribusiness.

That credit crunch has broken down cash grain markets.

For decades, farmers secured money for spring planting by selling crops forward -- signing contracts with local elevators for harvest delivery. To protect itself, or hedge, the elevator sells Chicago Board of Trade futures contracts to lock in prices. Banks demand such hedges as loan collateral.

But in 2007 and again this year, the system has broken down.

Grain firms that sold futures have watched prices soar to record highs -- and then keep rising. To hold hedges, agribusiness companies have bled cash and borrowed hundreds of millions of dollars to keep paying margin -- the good-faith payments needed to keep holding their short futures positions -- to the CBOT.

Finally, early this year many country elevators as well as large grain buyers like Archer Daniels Midland Co and Cargill Inc CARG.UL told farmers they were unwilling to buy grain more than 60 days in advance. Their finances were stretched. The farmers, and farmer-owned cooperatives, would need to finance their own hedges.

One result: the government-linked Farm Credit System, the dominant lender to farmers and co-ops, saw credit demand in January-March 2008 surge $10 billion, up 7 percent from 2007, as more and more grain elevators asked for expansions on their lines of credit to hold short futures positions.

The Farm Credit System is overall financially strong. We've seen the increase in demand coming from the Midwest because that's primarily where grain elevators are located, said Andrew Jacob, director of the Farm Credit Administration.


The Federal Reserve, the ultimate overseer of U.S. banking, is also keeping a sharp eye on credit demand. A survey of 300 rural banks this winter in the Kansas City Federal Reserve Bank's district found those in greatest stress were in wheat-growing areas: western Kansas, eastern Colorado and the Oklahoma Panhandle.

Our smaller banks are doing a lot more participations. As collateral requirements go up, if the bank individually cannot handle it, they'll partner or participate with another bank to pull a line of credit and make it work, said Jason Henderson, an economist at the Omaha, Nebraska, office of the Kansas City Fed.

Farmland prices, like grains, are also at record levels in the U.S. Plains and Midwest, where more than 200 million acres are planted to cash crops like wheat, corn and soybeans.

But soaring land prices make regulators nervous, reminding them of past boom-bust cycles. Could there be a credit bubble in farmland to echo subprime housing woes?

If there has been too much leveraged or loaned against the inflated value of farm land, the bubble will burst, Thomas Gronstal, Iowa's superintendent of banking, told the U.S. Senate banking committee in testimony on March 4.

Gronstal, whose state and Illinois usually produce a third of all U.S. corn and soybeans, said that the current speculative frenzy in farmland had elements of the 1970s boom before a crash that left thousands in ruins.


What could cause the speculative farm bubble to burst?

Biofuels, possibly. The craze to make fuel from corn and soybeans hit a crescendo in December as Congress -- pushed hard by farm lobbyists -- passed a stunning mandate to increase biofuels output five-fold over 15 years.

The frenzy of speculation that followed the December law took the battle for acres to epic heights. Corn and soybeans set record highs. Wheat and rice soared three to five times historical levels on fears of lost acres and dwindling supply.

But rising food prices around the world, which have sparked protests and hoarding of wheat and rice, have prompted a backlash against biofuels and calls for a rethink on last December's mandate. If that happens, the farmland and grain price bubbles could pop.

That could have a silver lining for grain hedgers. Indeed, wheat prices have fallen sharply since the winter panic, easing margin calls on wheat hedgers.

But it may be just the calm before the storm. All eyes are now on the volatile corn market. CBOT corn hit a record high of $6.79 per bushel last week, and corn remains the largest market for CBOT hedges, with 2007 production at 13.1 billion bushels.

The problem for these markets is what high point you have to go through and whether you have sufficient credit to make it through the high spike, said Swanson at Wells Fargo.

That's what the risk is this summer. If we get enough volatility we could break one of the links in the chain and all sorts of deals become unraveled.