HTA Disaster of 1996
The first HTA in Ohio and possibly the Corn Belt was written December 29th, 1984. It was done at Shepard Grain Company in southwest Champaign County halfway between Ohio/Indiana line and Columbus, Ohio just 15 or so miles north of I-70. George Shepard was the manager and grain merchandiser who wrote the contract for Dean Kite. Dean had always done his cash sales and forward contracts with Shepard’s.
Dean was a pretty sharp guy and he was real student of the markets. He noticed that every year he did a forward contract, which locked in the futures price and the basis, that at the time of delivery, Shepard Grain and Cargill in Dayton were paying a firmer basis than what he had locked-in with his forward contract. Dean saw the basis firm 10 to 15 cents by the time he delivered on the contract. Sure, the forward contract was the right thing to do because the futures price was usually 20 to 90 cents lower when Dean delivered his contracted corn than it was when he did the forward contract.
Dean’s records showed that every forward contract of which he had been a party, the basis improved a minimum of five cents and usually 15 to 20 cents. He was leaving money “on the table” so to speak.
George listened to Dean’s reasoning and agreed to lock in the futures, but not the basis. George asked, “What are we going to call this contract?” the three of us kicked it around and decided to call it a “Futures Only” because that is what it was.
Use of Futures Only contracts became a very competitive across Ohio in just a few short years. Someplace along the way, the name was changed to Hedge to arrive (HTA) and I think that came out of Illinois.
Grain merchandisers hated the HTA contracts. Basis improvement on forward contracts was a major profit center for grain merchandisers. However, if a merchandiser did not offer HTA contracts, he would lose business to those that did.
None-the-less, HTA contracts became wildly popular across the Corn Belt by 1994. Grain merchandisers learned to attach “bells and whistles” to the HTA marketing tool to gain a competitive edge and increase their profit margin through service fees that they lost on basis improvement. Not only were calls and put options attached to HTA contracts for a fee, but multiple year delivery periods were offered, for a fee, of course. A farmer could contract corn in June on a HTA at $3.14 in the December futures and, if corn rallied to $3.80, many merchandisers allowed the farmer to sell their corn at $3.80 cash and roll the HTA delivery to the next crop year, for a fee, of course. How sweet was that?! Many elevators allowed farmers to cash out profitable HTA contracts without ever delivering corn, for a fee of course.
A farmer had nothing to lose if he could postpone delivery on HTA contracts below the current market price and sell at the current cash price. All he had to do was wait for the price to go low enough to make money on his lowest price HTA contract.
In essence, such an elevator allowing a cash-out (with no delivery required) of a HTA was providing a speculative trading account for the farmer with the farmer never needing to meet the margin calls. Of course, elevators charged a very high “cancellation” fee of 10 to 15 cents a bushel, which their only cost was interest on the margin money and a fraction of a cent in commission for the futures transaction. No labor, no dust, no broken conveyors, no trucking and train headaches and almost pure profit per bushel.
A record crop in 1992 and again in 1994 pushed December 1994 corn to near $2.00. Basis was 35 to 50 under even here in Ohio. By the middle of December 1994, December 1995 corn was back up to the $2.55 range. It was a price that “everyone”, including me, was recommending farmers execute HTA contract for their 1995 corn crop. If prices did rally, puts and calls would capture the benefit of the rally. If corn did not rally, $2.55 sure beat the $2.05 farmers experienced in 1994.
Farmers across the Corn Belt, aggressively, unknown to me, sold multiple years of corn production on a December 1995 HTA contract with the intention of rolling in the fall of 1995 the 1996 and 1997 corn crop delivery to a later years or cashing out the HTA with no delivery.
Grain elevators collectively had billions of bushels of corn on the books, far more than ever before. All was good until the spring of 1995 when wet cold, weather delayed planting.
A wet spring and summer in 1995 motivated farmers to contract more and more HTA bushels as prices rallied. Grain merchandisers and elevators were short (sold) so many more bushels than ever before, they became worried about running out of margin money.
It was a very ugly summer as breach of contract by the elevators and farmers was the primary topic of conversation and “what are we going to do about it”. CFTC Commissioner John Tull warned insiders in May of 1995 that the HTA problem was giant boondoggle in the making and, yet, the CFTC did nothing.
The growing season was far from perfect and December 1995 corn slowly rallied to the $3.10 area by the end of November 1995.
The fall of 1995 was pretty ugly for grain merchandisers and farmers alike. Most contracts had been breached in multiple ways resulting in thousands of farmers across the Corn Belt with two or three years of production locked to HTA contracts at $2.55 and with December corn at $3.10 and climbing.
By late November 1995 the problem was the December 1996 was about 40 cents below the December 1995. To roll from December 1995 to December 1996 would reduce the value of the HTA by 40 cents. To avoid that loss, December 1995 HTA contracts were rolled to July 1996, which was about the same price as the December 1995 contract because it was the same crop year. The expectation was old crop prices would decline and/or new crop 1996 corn would rally during the first half of 1996 and then the July corn would be rolled to December in June.
The last week in December 1995, the Congressional General Accounting Office (GAO) issued a warning: “Some of today’s innovative grain contracts run the risk of being defined as futures contracts by the courts, which would make them illegal and unenforceable.”
Lawyers across the Corn Belt jumped on that tid-bit of news from the GAO and encouraged farmers holding HTA contracts to sue the grain elevators to get a legal ruling the HTA contracts were not legal contracts. Such a ruling would allow the farmers to walk away from the financial loss of their HTA.
The lack of clear-cut guidance on what was a futures contract and what was a cash grain contract was the single biggest unknown and it needed to be answered with a legal opinion. The CFTC did not want to issue a ruling that would bankrupt grain elevators because that would cost the futures exchanges (their customers) billions of dollars. State Departments of Agriculture, which regulated the cash grain markets, did not want to rule HTA contracts were illegal contracts because that would bankrupt their customers, the grain elevators. So, the decision as to what was a legal HTA cash contract was left to the courts all over the Corn Belt. Dozens of conflicting court decisions were issued through-out 1996. The first case with a HTA decision came from Minnesota and it was in favor of farmers. Grain industry people went… well, you can imagine.
All those HTA bushels in the December 1995 contract had to be liquidated by the end of November. Since December 1996 was 45 cents under the December 1995, those contracts were rolled to July 1996 futures at even money.
“Everybody” knew the grain elevators were short so many bushels of July corn, they were in perilous danger of running out of money. The big spec funds bought and bought and bought July corn beginning in April 1996 and sold and sold and sold December corn. A financial disaster resulted as there just was not enough corn and not enough money to cover the losses.
Grain elevators generally made a command decision that it was better to take their chances in court over breach of contract issues than to negotiate a settlement with all the farmers holding HTA contracts. The thinking was farmers would not hire lawyers and those that did, would soon lose their desire to fight in court as the legal bills mounted and the grain industry’s lawyers wore out the “country hick lawyers” with request for discovery materials (five years’ tax returns, bank statements for the past three years, trading account documentation for the past three years, etc.).
It was truly an ugly situation and it was caused by poor discipline of the additional “tools” that elevators allowed to be attached to the HTA contracts. Those additional tools were made available so the elevators made in service fees what the elevators lost on basis appreciation when forward contracts replaced by HTA contracts.
The big boys (ADM Cargill, Bunge, etc) had enough sense not to offer these foolish bells and whistles. As elevators went out of business, the “big boys” bought all those elevators for pennies on the dollar.