The subprime mortgage house of cards that brought chaos to the world's financial sector is also “going to come home to roost” for farmer borrowers in the form of higher interest rates and tighter credit.

Many in agriculture may not be prepared for either scenario, says David Schweikhardt, professor in the Department of Agricultural, Food, and Economics at Michigan State University.

“In agriculture the last few years, there has been too much happy talk,” he said at the annual conference of the Mississippi Agricultural Economics Association at Mississippi State University.

“U.S. farmers have seen record farm income; farm balance sheets have never been better. But a lot of producers have a far too casual attitude for the situation we're in. This financial crisis is not a scenario from the movie ‘It's a Wonderful Life.’”

In 2009, farmers should “look for higher interest rates and tougher lending standards,” Schweikhardt says.

“We should be prepared for an inflation scenario, or a deflation scenario, or both. The immediate risk, I think, is deflation, but after a year or two, inflation with high unemployment rates.”

With the emphasis on biofuels in recent years, “agriculture has tied itself to the oil sector,” he says. “Now, the instability in the oil markets has been imported into ag markets — if oil goes up, corn goes up; if oil comes down, corn prices drop.”

Agriculture gets 24 percent of its credit from the Farm Credit System, 45 percent from commercial banks, and 22 percent from other sources, such as equipment manufacturers and other input suppliers, Schweikhardt notes.

“A lot of smaller banks are facing problems of their own with construction or commercial real estate loans going bad, so they're going to be imposing more stringent lending standards.

“We're no longer in a liquidity crisis — we're in a security crisis. Financial institutions won't lend because they don't trust anyone. Federal Reserve Chairman Ben Bernanke has been trying to avoid deflation by shoveling money out the door, but banks have just been putting it in their vaults and not lending.”

What has taken place, Schweikhardt says, “is not just a meltdown of the mortgage credit system, but a meltdown of the entire financial system and every form of credit within that system.” Brokerage companies “were slicing and dicing mortgage instruments, with no capital whatsoever on the line; they were running shell operations, giving mortgages to people who couldn't repay.”

In 2006, he says, 50 percent of all subprime mortgages were low- or no-documentation loans which made no effort to determine whether the borrower had any assets or income, or even a job. “When you look at those numbers, you wonder: Had we lost our collective minds when we were lending money without doing even the most basic checking on a borrower's ability to pay?”

And it all was taking place with little or no regulatory oversight, Schweikhardt notes.

“There was a giant supervisory hole. Some 52 percent of subprime mortgages were originated by companies with no federal supervision. The Federal Deposit Insurance Corporation, which had 15,000 bank examiners in 1991, today has only about 4,500.

“The Commodity Futures Trading Commission was actually prohibited by legislation from even suggesting that these instruments be regulated or from promulgating, interpreting, or enforcing rules.”

The Federal Bureau of Investigation had fewer agents devoted to white collar crime investigations than in 2001 — only about 2,000. From 2000 to 2007, securities and commodities fraud cases brought by the FBI to criminal prosecutors dropped by 21 percent and bankruptcy fraud cases declined 38 percent.

“The theory was that banks would self-regulate in order to protect their stockholders and their reputations,” Schweikhardt says. “Even former Fed Chairman Alan Greenspan has admitted he erred in that thinking.”

The value of credit default swaps, an esoteric offshoot of the subprime mortgage market, went “from non-existent in 2000 to an estimated value of $35 trillion in 2008 — this, while the entire U.S. gross domestic product was only about $12 trillion or $13 trillion.

“We don't even know who holds all this paper. This creates an invidious environment of mistrust, which spreads through the entire financial sector, paralyzing the system. What we're seeing now is a flight to quality, with investors refusing to buy securities of unknown quality.

“We've got a long way to go to get the housing market back,” Schweikhardt says. “It is generally agreed by analysts that housing prices have to fall 30 percent from their peak. Thus far, they've fallen about 15 percent.

“While we've been assuming that the 30 percent decline would return us to a normal historical level, now we will almost certainly have a serious recession on top of that 30 percent drop. That will likely cause the housing price level to drop even more as the market overshoots that historical mark.

“Will it be 40 percent, or even 50 percent. Nobody knows, but there is now a serious possibility that it will exceed 30 percent.”