* Returns on assets, equity improve at ag banks
* Machinery and equipment loans rise
* Farmland values rise to record highs
By Christine Stebbins
CHICAGO, July 25 (Reuters) - Demand for agricultural loans at U.S. commercial banks rose during the first six months of 2012, led by farmer loans for machinery, grain bins and machine sheds, the Federal Reserve Bank of Kansas City said on Wednesday.
"During the first quarter, commercial banks reported a 1.4 percent increase in total agricultural loan volume, led by stronger gains in non-real estate farm loans," the Fed said in its agricultural finance databook based on a national survey of 250 ag bankers.
"A sampling of national agricultural loan activity during the first full week of May suggested strong agricultural lending during the second quarter," the Fed added. "Non-real estate loans were up almost 3 percent from the previous year."
The survey showed that cash-rich farmers were managing and retiring their debt carefully but upgrading their land and equipment actively.
"Farmers continued to invest heavily in farm machinery, equipment and structures such as grain bins, machine sheds and land improvements. Bankers expected farm capital spending to remain strong over the next few months," the Fed said. "In contrast, farm operating loan demand remained sluggish as farmers paid off operating debts and used cash to prepay input costs."
Most bankers expect investment to continue to buoy demand, although the worst effects of the 2012 drought were not yet seen through end-June.
"Bankers expected farm capital spending to remain strong over the next few months," the Fed said. "In contrast, farm operating loan demand remained sluggish as farmers paid off operating debts and used cash to prepay input costs."
Strong farm incomes fueled farmland values to record highs.
Farmland saw double-digit gains in Iowa, Kansas, the Dakotas, Minnesota, Montana, Nebraska, northern Illinois, western Missouri, northern Indiana, and southern Wisconsin during the first quarter of 2012.
"Compared with December 2011, more bankers in the Chicago, Dallas and Richmond Districts expected farmland values to stabilize at historically high levels in the coming months," the Fed said.
Agricultural bank profits rose as farm loan performance improved. Rising farm loan repayment rates reduced delinquency rates and net charge-offs on ag loans. But competition to win loans from cash-rich grain farmers was increasing pressure on bank profitability.
"Strong farm incomes continued to dampen farm operating loan demand in most Federal Reserve Districts," the Fed said. "Farmers borrowed less for operating expenses in the Chicago, Kansas City, Minneapolis and San Francisco Districts as they paid cash for crop inputs. High feed costs and strong feeder cattle prices prompted further herd reductions in the Dallas and Kansas City Districts. Herd liquidations have boosted current profits, but could limit growth in the future.
"With sluggish operating loan demand, the availability of funds for farm loans remained high. Collateral requirements on non-real estate farm loans eased slightly in all Districts except Chicago, where collateral requirements held steady. Bankers reported lower interest rates on farm loans in the first quarter," the Fed said.
For the first quarter of 2012 the rate of return on assets at agricultural banks rose to 0.3 percent -- nearly double the return at other small banks. Additionally, the average rate of return on equity was 2.7 percent at ag banks versus 1.7 percent at other small banks.
"During the second quarter, small- and mid-sized commercial banks increased their non-real estate lending activity at a faster pace than large banks," the Fed said. "The volume of non-real estate agricultural loans made during the week at small- and mid-sized commercial banks was 12 percent above year-ago levels, while loans at large banks edged down." (Reporting by Christine Stebbins; Editing by Lisa Shumaker)