As seen in the September 16th issue of Business Lexington.
The state of the economy, the recession and numerous but unsuccessful attempts to stimulate the economy are certainly the No. 1 topic each day in the national and local media. A similar sharp decline in the sales prices of Thoroughbreds beginning in earnest in 2009 has significantly impacted Kentucky's signature industry.
In 2009 and 2010, almost all of the major sales in Kentucky, Florida and New York, as well as internationally, experienced declines in the major indicators of gross sales, declines in sales averages and medians, while there were substantial increases in the rate of horses unsold. The markets continued their downward slide at all levels, including mares, two-year-olds, yearlings and a decline in the value of stallion prospects. Faced with challenges in their primary business sectors coupled with declines in the values of their bloodstock, many buyers exited the market, either partially or entirely. Demand dropped and the number of live foals produced dropped in response, from a high of 34,294 foals born in the United States in 2007 down to 24,900 foals produced in 2010 (see 2011 Jockey Club Fact Book). Kentucky also saw fewer mares bred to Kentucky stallions and more mares and stallions relocated to other markets, such as Indiana and Pennsylvania, where the outlook is better due in part to breeders' awards programs supplemented by revenue from slots or casinos.
The equine lending industry was an additional casualty of the decline in equine market values. Like other business owners, many breeders in central Kentucky were funded in part by bank lending. Several regional banks lend on Thoroughbred breeding stock (although typically not on racehorses due to the risk of injury and volatility in value). When the market experienced sharp and sudden declines, many breeders found themselves out of margin under the terms of their loan documents.
While loan terms vary, a typical equine loan provides that a borrower's equine portfolio must appraise at a minimum of twice the value of the outstanding loan amount (the "borrowing base") — in other words, a 50 percent loan-to-value (LTV) standard, to use a familiar real estate term. This is referred to as an affirmative covenant — meaning a promise that the borrower makes for the term of the loan. When the major commercial yearling and two-year-old sales averages are down 22 percent to 24 percent in one year (2009) and average sales prices for broodmares are down 23 percent in 2009 and 10 percent in 2010 (see Dean Dorton Allen & Ford's 2010 Year in Review), what previously seemed like a conservative lending position became a loan in default. A directly parallel scenario is found in certain real estate markets that devalued almost overnight in the wake of the financial crisis. Other industries have experienced similar scenarios. While the collateral is unique, the challenge is not unique to the equine industry.
Once such a decline takes place, lenders are required to take steps to have borrowers cure the default. A cure can take several forms. Borrowers can pay down the amount of the loan that exceeds the borrowing-base limit — in other words, come up with cash. Alternatively, borrowers can offer the bank more equine collateral to correct the loan-to-value status. Unfortunately, many borrowers were unable to do either. Borrowers were either unable to sell their bloodstock, or the bloodstock that did sell were worth significantly less than before.
If the borrower is unable to offer more collateral or pay down the loan balance in order to comply with the loan covenants, the loan will move to work-out status with the lender. For borrowers proceeding to work-out, the key is communication with the lender. Often borrowers who are sued by lenders are sued as a result of a lack of communication or refusal to communicate or cooperate. The lender must be assured that the borrower is doing whatever he or she can to correct the situation and minimize the losses with which the lender is faced.
A forbearance is an agreement by the lender not to proceed to exercise certain rights and remedies available under the loan documents or pursuant to common law and to agree not to exercise those certain rights for a defined period of time. In return, the borrower agrees to work with the lender to take certain steps to attempt to pay off or reduce the outstanding loan during that period. Forbearance agreements, whether equine or otherwise, typically provide for revised payment structures and interest rates, sale or liquidation of collateral, provision of business plans and more frequent internal reports and/or the hiring of outside professionals for analysis or operation of the business. If a borrower is able to offer additional or different collateral such as accounts receivable, assignment of contract rights or rights to payment or a mortgage on real estate, the lender may deem itself more secure and a restructure of the loan may be possible.
One significant complication in the equine industry is the existence of competing agricultural liens, such as board bills (agisters' liens) and stallion service liens, which are state-created statutory liens. The Uniform Commercial Code governs the priority of such liens, but some questions of priority under certain narrow fact patterns have yet to be resolved by the courts. Generally, bank liens are first in priority, having been filed and perfected at the secretary of state level before the other liens. However, unpaid stud fees and board bills must be addressed in any work-out or forbearance agreement. Boarding farms are unlikely to care for the bloodstock or prepare them for sale without some reassurance that they will be paid in whole or in part, and young horses cannot be registered without the stallion service certificate. The stallion service contract generally provides that the certificate will not be turned over by the stud farm until the stud fee has been paid. In most circumstances, a compromise is worked out between the parties.
The equine market, like other markets, may have stabilized. Some indicators of late indicate a plateau in values and point toward recovery. Recent sales in Lexington and Saratoga showed some positive trends. A smaller crop of foals offered at the sales coupled with increased demand as buyers become more active and confident in the economy should fuel stronger prices and lower buy-back rates.