* Robust farm economy lifts profits for top U.S. ag lender
* Drought raises red flag on outlook, grain farmers insured
CHICAGO, Aug 1 (Reuters) - The U.S. Farm Credit System, a government-sponsored enterprise and the single largest lender to U.S. agriculture, said on Wednesday second-quarter net earnings rose 8.7 percent, reflecting a strong agricultural economy.
The System, which funds its lending to farmers and agribusinesses by issuing debt securities to domestic and foreign investors, earned $1.067 billion, compared with $982 million a year earlier.
"The System has managed well through the past few years of a strong agricultural economy," Tracey McCabe, chief executive of the Farm Credit Funding Corp, which funds FCS securities, said in statement.
But McCabe said the System is closely monitoring the worst drought in half a century to gauge its effects on farm balance sheets.
"The strong financial positions of our borrowers and risk mitigation efforts such as crop insurance and the hedging of input costs will tend to minimize the adverse effects of the present weather conditions," he said. "However, some borrowers that depend on crops for inputs may be negatively affected as the implications of the drought unfold."
The $85 million rise in net earnings in part reflected a drop in the provision for loan losses of $91 million and a net interest income rise of $37 million.
Net interest earnings were $1.6 billion for the quarter, up 2.4 percent.
FCS reported provisions for loan losses of $35 million for the quarter that reflected the stress in agricultural sectors affected most by volatile commodity prices: livestock, ethanol and dairy.
"These factors, as well as the drought's impact on crop prices and yields, are expected to weigh on the livestock, ethanol, dairy and poultry industries and other agricultural sectors in the future," the FCS said.
Gross loan amounts increased $6.855 billion or 3.9 percent, to $181.519 billion as of June 30, compared with $174.664 billion at end of 2011. The rise reflected more real estate mortgage loans amid strong demand for loans tied to farmland. (Editing By Peter Bohan)