The term Hedge to Arrive (HTA) is commonly used to describe a contractual arrangement between a farmer and an elevator with the following general characteristics:

1. The elevator contracts with the farmer for the farmer to deliver grain at a future date at an agreed upon price and hedges the sale in the futures market on behalf of the farmer.
2. The elevator then makes any required margin calls on the farmers behalf until the contract matures.
3. The farmer assumes responsibility for the basis risk any gains or losses which have been generated.
4. The farmer is in control of the position and rolling may be permitted according to the terms of the agreement.

This type of contract has been used by elevators in the Midwest for a number of years and in the western corn belt for about the past five years. During the past several month some HTA contracts have been the source of significant losses for farmers and their elevators. In some cases these losses have reached the magnitude where there are potential losses for farm and elevator lenders. The position of each will be examined in this testimony.

Country Elevator's Position

Country elevators found themselves in a "no-win" situation with respect to Hedge-to-Arrive Contracts (HTA) in the current unstable market situation. From the very start, most elevator managers have been at best uneasy with the typical Hedge-to-Arrive Contracts (HTA). With a very few exceptions, the contracts were offered in response to competitive pressures rather than being actively promoted by elevators themselves. There are several reasons why:

1. The contracts require the elevator to provide the cash to cover margin calls prior to the closing of the contract. While the elevator must also make margin calls on regular cash forward contracts, an additional credit risk is introduced under the HTA contract. In cases where the market moves against the futures position it is the farmer not the merchandiser who is in control of the position. This leaves the elevator powerless to exit or roll promptly in response to changes in the market. Thus the potential amount of margin credit which the elevator may have to extend on the position is open-ended. And if the producer fails to perform on the contract, the effects on the elevator could be a financial disaster.
2. The elevator also loses a degree of control over its own merchandising function when the producer decides to roll the contract rather than delivering in the month the contract initially specified. Incomplete control of inventory often results in costly uncertainties in scheduling transportation (another risk factor) and in some cases, the lost opportunity to make profitable sales.
3. Finally the elevator gives up the basis appreciation that might accrue to a cash forward contract hedge made in anticipation of the delivery. Thus under a typical cash forward contract, the elevator would usually generate a return on the hedge position to cover the cost of borrowing for margin calls. But with a hedge-to-arrive contract, the producer keeps that gain. These limitations on the elevator's position make the contract less than ideal for the elevator. Viewed strictly from the elevator's perspective, the cash forward contract would be preferable.

The Farmer's Position

The elevator position with these contracts has been further complicated by farmer's desire to capture higher market prices for corn and soybeans to be produced in future years. Many producers and their lenders are simply attempting to cope with the increased price uncertainty created by the phase-out of government price support programs. Opportunities to price future crops at above the cost of production (in the absence of the traditional price support programs and without any planting restrictions to moderate total supply) were undoubtedly attractive. Producers with significant debt service obligations who were confronted with increasingly uncertain price prospects most likely felt it prudent to price ahead.

This put additional pressures on the elevator to accommodate producer demand. While HTA contracts are not an appropriate vehicle for forward pricing future crops, they were indeed written for future years in many cases. This underscores the lack of understanding about the true nature of HTA contracts on the part of many farmers and some elevators. It is these multi-year contracts that are most vulnerable in the current unstable futures market. Values of these contracts will be severely eroded from margin calls and the process of rolling them forward into the period when the production will actually occur and when delivery is anticipated by the elevator.

Both producers and elevators share a significant financial and legal risk in attempting to deal with their multi-year HTA contract problem. Rolling these contracts through the severely inverted spreads in the futures market that show little promise of correcting in the near future, is a losing proposition. The producer will receive only a fraction of the contract price if the contract is held and rolled. The elevator may run the risk of CFTC violation if the contract is cashed out to avoid further losses, particularly if the facts and circumstances indicate there are no expectations or possibility for delivery in any event.(See Attachment Harl) The elevator will continue to finance the large margin calls with a possibility that they will grow even larger. Despite the fact that exit (and perhaps some form of loss sharing in the most extreme cases) may be necessary there are uncertainties about how the parties should exit this highly speculative situation and cut their growing losses.

It should also be noted that the elevator=s risk management problem is not confined to HTA contracts alone. Severe problems with the prolonged inverted spreads in the futures market also make risk management of existing company-owned inventory very difficult, if not impossible. Elevators unable to use traditional means to manage risk will need to alter operations dramatically. There is simply not enough equity in the country elevator system to absorb the level of risk in these extremely volatile markets. Much higher grain margins will be necessary when risk management through futures market hedging is not a viable alternative.

The Elevator Lender's Position

In 1995 and early 1996, elevator lenders in the western cornbelt found themselves in an unusual situation aside from the HTA. issue. Severe transportation problems in the summer and fall of 1995 left grain inventories in some elevators at very high levels. Steady and significant price increases during the winter and spring of 1996 added value to the inventory and raised margin requirements on hedge positions. In order to meet borrowers needs for financing inventory required the extension of much larger than normal amounts of operating credit which would presumably be repaid when the grain was shipped and payment received by the elevator.

There was little or no way for lenders to separate the HTA. activity in the hedge accounts (exposed to greater credit risks) from normal risk management hedge activity conducted by the elevator. Thus credit was in effect unknowingly extended to some elevators with significant HTA. activity imbedded in their hedge accounts. Only when most of the grain had been shipped and there was still a significant need for seasonal operating credit to cover cash tied up in margin accounts, did the severity of the situation become more transparent. At that point, little could be done by lenders to put the genie back in the bottle. The contracts were issued, the futures market positions were in place, the margin calls had been made and the markets spreads were seriously inverted.

Problems Of Lenders To Producers

The huge losses incurred by some producers will place the lenders in a position of restructuring loans and in some cases, asset restructuring may need to be considered. They will also be confronted with attempts by elevators to recover losses through work-out arrangements. In a number of cases, the losses incurred by producers thus far exceed their net worth by a considerable margin. These cases will be difficult to resolve - short of bankruptcy - without outside assistance from some source.

Addressing The Problems With HTA Contracts

However, the multiple year contracts without well defined rolling provisions are not likely to lead to beneficial (or even benign) results for either the producer or the elevator. If these multiple year contracts are held until the out year when production actually occurs and delivery can finally take place, huge losses will almost certainly occur. In general these positions will have to be lifted and the elevator and the farmer will have to settle the loss that has occurred to date. Since the elevator has made the margin calls on the farmer's behalf while the contract was in force, it is in the position of having to collect for the loss. If the farmer is capable of meeting this obligation and an agreement can be reached the problem is resolved. If on the other hand the farmer's loss exceeds the capacity to pay (or if an agreement to take responsibility for the position can't be reached), the losses are left in the elevator. In these cases the elevator is in the position of either bringing suit or swallowing the loss. The equity position of the elevators is typically not sufficient to absorb very large losses of this type. Some types of work out plan with individual producers may be the best compromise.

The severity of the problem and the elevator's ability to deal with it depends on several additional factors. The mere fact that an elevator has written some multi-year HTA contracts does not necessarily signify that a severe problem exists for either the farmer or the elevator work-out solutions will be possible for at least some kinds of multi-year situation. When multi-year contracts are in place, the feasibility of work out solutions will depend on the following other factors:

1. The total number of bushels sold on multiple year agreements.
2. The number of producers who account for those bushels.
3. The financial strength of the producers holding those contracts.
4. The financial strength of the elevator.
5. The integrity of and provisions in the contract used.
6. The will of the parties to reach a solution according to the intent of the agreement.

If the total number of bushels under multi-year contracts is relatively small compared to the elevator's total volume, the problem is obviously more manageable. Likewise when the multi-year contract bushels are distributed over a relatively large number of producers (each with a modest number of bushels under contract for later years) the problem is less serious than when large volumes are in the hands of a relatively small number of farmers. The probability of reaching an acceptable solution is much greater when the stakes for each individual producer are smaller ---even though it will be necessary to deal with a larger number of individual producers. Financial strength of both the producer and the elevator are also important in reaching an acceptable agreement promptly. The number of practical alternative workout agreements is usually increased when both partners have sufficient net worth. Finally where the contract language is complete, clearly stated, and specific there is a greater possibility that an acceptable agreement can be reached promptly.

It now appears that in the majority of cases some type of settlement will be able to be reached to address multi-year contracts. This does not imply that the process will be painless or that individual farmers and their elevators will not suffer significant losses. It means only that in the majority of cases, the results will not be disastrous to the farmers, the elevator, their lenders and the elevators other patrons.

Unfortunately in a few cases the multi-year contracts have been written for larger volumes of grain with a relatively small number of producers under somewhat loose contract provisions. In these elevators a significant problem exists and the dimensions of the problem may be greater than the direct parties to the contract can manage. Additional equity capital and debt capital would then be needed by the elevator and in some cases the operations may have to be merged into another elevator.

The need for additional debt capital is especially troublesome in that the losses arising from HTA contracts do not generate cash flow for repayment. The elevator's lenders are certain to be reluctant to issue additional debt capital to their borrowers to manage these losses beyond a certain point. Where it becomes imprudent to make further loans based on the elevators balance sheet, a difficult credit decision has to be made. From that point and beyond some type of Balance Sheet asset will be required to back any further losses to the elevator.

One approach in these more extreme cases might be a reduced interest partially (or fully) guaranteed loan which could be issued to the producers for losses that are very large. These loans would be targeted specifically to back loans extended by the elevator. In at least some cases, the elevator's lender might view this as a sufficiently safe asset to back the issue of additional credit to the elevator using the loan as an asset. This would relieve some of the pressure on the producer's lender as well. Since the elevator is likely to request a secured note from producers to cover the portion of the loss not repaid in cash, the producers credit position with the other lenders could perhaps be maintained at an acceptable level.

If settlement cannot be reached through negotiation or through placing acceptable guarantees under the debt so that it can be worked out over time, still other less desirable forms of resolution will have to be used. Unfortunately, the remaining options involve either litigation or discharge of the debt through farm bankruptcy. These alternatives usually carry very large transaction costs and have detrimental effects on others in the community who were not directly involved in the transaction.

For more information, contact admin@econ.iastate.edu.