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It doesn't matter what marketing experts advise. In the real world's uncharted sea of money, financial icebergs lie beneath the surface. In October 2008, VeraSun Energy, one of the largest ethanol makers, filed for bankruptcy, reneging on forward contracts with farmers. Three years later, MF Global Holdings, Ltd., was bankrupt after raiding $1.6 billion from customer accounts, as its own bets in shaky European bonds soured.
All this leaves farmers like Clinton J. Blew of Pretty Prairie, Kansas, more cautious and skeptical than ever. In the early days of the MF Global collapse, as chairman of his Mid Kansas Cooperative Association in Moundridge, he was getting phone calls from neighbors worried that the co-op would be taken down by its initial loss of $1.2 million from a hedge account cleared through MF Global.
Today, the co-op has recovered the majority – but not all – of its funds. Blew is glad he didn't hedge with futures on his own. And he's uncertain of help from Washington to prevent future theft from segregated accounts – something already illegal and supposedly regulated.
“It's kind of like the farm bill. Everything just moves really sluggishly,” says Blew, who was asked to testify before the Senate Agriculture Committee when it held a hearing on MF Global's collapse in December 2011.
“I'm not a Washington guy. I haven't been up there a whole lot,” he says. After several recent trips there, he says, “I have a new appreciation of how everything works. I don't know that I have any more respect for those guys.”
So far, trustees have restored about 72% to 80% of losses to farmers, co-ops, and other hedgers, with speculators offering to buy out over 90% of claims. The futures industry was embarrassed by yet another theft from hedgers, the collapse of Cedar Falls, Iowa, brokerage Peregrine Financial Group (PFG). In September, its former owner, Russell Wasendorf, pleaded guilty to mail fraud, embezzlement of customer funds, and lying to regulators. He detailed his crimes in a note in a suicide attempt last summer. Up to $200 million was misappropriated. Clients expect to recover less than 50%.
The Chicago Mercantile Exchange has set up a fund to protect small hedgers from future thefts; some say it's too modest. Congress is considering a larger fund modeled after the Securities Investor Protection Corporation (SIPC). Senator Charles Grassley, an Iowa farmer on the Senate's Agriculture and Finance Committees, says he doesn't expect that to come up this year.
Meanwhile, farmers wonder if industry-financed funds or more regulation will just make their own grain sales more expensive. Some aren't using futures contracts, a small factor perhaps in a recent decline in commodity futures trading volume. Others, even some who lost money from the hedge accounts to MF Global, see little choice but to continue using futures in a volatile marketplace.
No Simple, Easy Answers
The main lesson for Blew is to really know those who buy or trade his crops. The chance that they won't honor their contractual obligation is called counterparty risk.
“I knew it before, but it certainly hammers home the fact that I need to know where my counterparty risk is and what it is,” Blew says. “Ironically enough, the co-op had just gone through enterprise risk management.”
It hired a consultant to find counterparty risk in businesses the co-op deals with. “Something like this never came up. Nobody ever mentioned this,” he says.
Blew says the co-op's own financial soundness was never seriously threatened, and it had support from lenders.
Team Marketing Alliance, the hedging arm owned by MKC and three other co-ops, uses the Advance Trading brokerage that cleared through MF Global.
“I think, in the past, a lot of this was based on relationships, for better or worse,” Blew says.
For his part, Blew doesn't use futures on his own to hedge.
“I had done some futures trading when I first started farming. I got burned on it. I had to pay a lot of margin, and it kind of strained my operating note,” he says.
He buys fertilizer and other inputs through the co-op, so he prices his grain there. The co-op staff “are helping me manage my margin,” he says. “For me, I never felt the effects that people had from MF Global. I was insulated through the cooperative. As a producer, I essentially laid the risk off with them,” he says.
Sticking with futures
Steve Wellman, a Syracuse, Nebraska, farmer, did lose money when MF Global failed.
“The broker I was using had MF Global as its clearing house, and we had outstanding funds,” he tells Successful Farming magazine.
He counts himself lucky that he didn't have much in his hedge account.
“The markets had turned around; I had some cash equity in there, and I pulled it out,” he says.
He's been repaid about 72% and has less than $10,000 from his original hedge account that he hasn't yet recovered.
Wellman doesn't fault his broker for the bad luck of clearing futures through MF Global. He still uses the same one; it now clears through R.J. O'Brien (RJO).
Other clearing firms did take over the business for brokers. But it wasn't an instantaneous process. Wellman says brokers get little sympathy. “I know they lost business because of the MF Global bankruptcy and not being able to trade.”
Wellman, who is currently serving as president of the American Soybean Association, isn't certain that he personally supports setting up a fund to protect hedges in the way that the SIPC protects investors who buy stocks.
“That might be fine, but who's going to be paying the bills? It's going to be the customers. I'm not sold on the customer bearing the cost when laws have already been broken,” he says.
Ray Gaesser, Corning, Iowa, is another farmer sticking with futures contracts. Not long after VeraSun's failure, he quit selling as much of his crop with forward contracts and decided to hedge more with futures.
“It doesn't matter whether it's an ethanol plant or a local elevator, there's still a lot of risk,” Gaesser told Successful Farming magazine for an article published in 2009.
Gaesser was unaffected by MF Global or PFG, and he hasn't quit using futures.
“I still do about half and half,” he says. “I've always hedged some and contracted some.”
“The downside to forward contracting is you need to deliver, and this year a lot of people are struggling with that,” Gaesser says.
In order to lower the risk of clearing firm losses when using futures, some suggest using more than one broker, making sure each has a different clearing firm.
Gaesser believes that would make it harder to stay with a marketing strategy.
“It's easy to get caught up in the market and forget why I'm there and what my goals are,” he says. “I don't think it would be a good idea. I think one account's plenty to watch out for,” he says, laughing.
Still, Gaesser is cautious these days.
“I think we all need to do due diligence when we put in hundreds of thousands of dollars, before we do business with a company, whether it's buying inputs, machinery or hedging,” he says.
Searching for solutions
Farmers weren't the only ones directly affected by MF Global's demise. So were hundreds of members of the National Grain and Feed Association, says Todd Kemp, the group's vice president of marketing and its treasurer.
The group is seeking three changes from Congress:
- Change U.S. bankruptcy laws to put segregated hedge accounts first in line for recovery of assets.
- Set up a more fully segregated account structure for customers that would be voluntary and paid by hedgers.
- Establish an insurance fund to cover losses in hedge accounts, similar to SIPC.
“Before any decisions are made on this, we're going to look carefully at who should be covered, how much should be covered, and how much it's going to cost,” says Kemp.
Washington's other big grain buyer lobby, the National Council of Farmer Cooperatives, also wants to restore confidence in futures trading, says Chuck Conner, the group's CEO.
But it hasn't taken a stand on an insurance fund, he says, partly because the group worries about how any increased costs might affect smaller futures commission merchants such as Country Hedging, a subsidiary of the cooperative CHS, Inc.
CHS is the largest U.S.-based cooperative. But its hedging arm, with net capital of $23.9 million, is a modest-size Futures Clearing Merchants (FCM) among giants like ADM Investor Services with $284.7 million and RJO, the nation's largest independent futures brokerage, with $206.3 million. (Those numbers are July 31 adjusted net capital reported to the Commodity Futures Trading Commission in September.)
Country Hedging President Scott Cordes says his brokerage has already added staff to comply with new regulations from the Dodd-Frank financial reform law. A new industry-funded insurance program adds more costs, he says.
“I'm concerned that some of this regulation is going to force some consolidation and put the industry in fewer hands,” Cordes says. The futures and swaps industry may be enormous, but there are only about 10 to 11 FCM specializing in ag commodities, he says.
Still, the futures industry needs to do more, he believes. The CME fund to cover losses by small hedgers, limited to $25,000, “is a step in the right direction to instill some confidence. Some people would doubt if that is enough,” he says.
With between $250 million and $400 million in its customer-segregated accounts, Country Hedging has picked up business after MF Global's demise, he says. “Our customers are our owners.”
But MF Global and PFG hurt confidence in the futures industry, he says.
“It affects volume,” he says, noting that the futures industry has seen a decline in trading volume this past year due to many factors.
“Somehow, as an industry, we have to get confidence back into the system,” Cordes says.
That may take time. MF Global's former CEO, John Corzine, is unlikely to face criminal charges. But the CFTC and Securities and Exchange Commission could bring civil suits. And the trustee liquidating MF Global's broker-dealer unit is still seeking customer funds.
“I think we have the regulations in place to keep this kind of thing from happening,” says Kansas farmer Blew. “They just weren't enforced. I don't think we've gotten to the bottom of this.”