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Is my futures account safe in the current credit crunch / liquidity crisis?

August 20, 2007

 

It sure has been hard to turn on the TV or pick up a newspaper these days without reading about the "liquidity crisis" or "credit crunch" which everyone has been blaming for the 10% fall in US stocks over the past few weeks.

And while it seems that hedge funds, private equity firms, and sub prime mortgage lenders are mainly the ones who are suffering from these issues - more than one investor has called Attain asking whether assets in a futures account are safe in this liquidity crisis. The questions have a similar tone, asking 'What if the clearing firm goes out of business' or 'what if the bank the clearing firm puts it money in goes out of business.

In a general answer to the question of whether investors money in futures accounts is safe? I personally believe one of the safest places an investor's money could be right now is in a futures account.

Liquidity Crisis - a Summary

To explain why, let's first revisit why there is a liquidity crisis right now resulting in some of these firms going bankrupt and some hedge funds folding. It all comes back to the housing market boom over the past 10+ years. With millions of people buying homes, and borrowing money at historically low rates to do so - the number of mortgages in the world was increasing very quickly.

All of these mortgages were pooled together, bundled up and sold by the mortgage companies or their investment bankers to institutional investors like hedge funds and other banks. A hedge fund would borrow money at say, 4%, and buy a pool of mortgages which paid 6% annually - and voila, a net profit of 2% per year. But no one is going to sign up for measly 2% profits per year - so what do the hedge funds do - they leverage the heck out of their borrowings, so that they only put up 10% of what they borrowed, thus turning that 2% return into 10 times that - a 20% return.

This was a nice game - the banks would get to loan the hedge funds big sums of money; the mortgage companies would get to keep issuing more and more mortgages (in fact, they would even loan out more money than they had, always relying on the hedge funds/banks/etc to be a buyer of whatever mortgages they sold), and the hedge funds would seem like they were printing money, generating nice consistent returns with seemingly no risk.

The missing piece here, of course, was the inherent risk in the pool of mortgages that some of the mortgage borrowers would default on their loans. This started to happen with more and more frequency as people with exotic adjustable mortgages and people who maybe shouldn't have been borrowing money in the first place (sub prime) could no longer afford their monthly payments due to interest rates moving higher. Without the people paying their mortgages, the income stream for a pool of mortgages goes down, and the rate goes down, and in turn the value of that pool of mortgages should go down.

Now, this still didn't slow down the game entirely, until Wall Street giant Bear Stearns killed the Golden Goose by trying to get out of this game in two of their hedge funds. To get out, they needed to sell the pools of mortgages they had. Problem was - nobody wanted to buy them. Not at 70 cents on the dollar, not at 40 cents, and not at 20 cents. The prices of these pools was plummeting - and until then everyone had just been making up prices for them on their own books. They would use formulas and the like to generate what they thought the pool of mortgages was worth, but you never really know until you try and sell them.

When Bear Stearns couldn't sell their funds - everyone else in the game had to mark their pools of mortgages to the market. And boom, rather liquidity crisis or credit crunch was on. The hedge funds which had these things priced at 100 now had to price then at 50 or lower. And any other positions they were in which were using the asset at 100 to borrow money to pay for, were now on margin calls. They now had to come up with real money to pay for things, to hold positions, and the like; and to come up with that money they had to sell all sorts of positions - stocks, commodities, whatever.

But at the same time, they stopped buying the pools of mortgages from the mortgage companies. So anyone who didn't have a whole lot of their own cash to lend out quickly went bankrupt. They had loaned out more money than they had to loan.

And this also led to a tightening of lending standards so that the lenders weren't exposed to the risk of defaults. This put private equity deals in danger, normal withdrawal requests from firms like E-Trade, and hurt supposedly very safe debt like GE notes under pressure.

The end result has been dozens of bankrupt mortgage companies, a few prominent hedge funds losing nearly all their investors money, and the most volatile stock market we've seen in years.

Is your futures account safe ?

So what does all this mean for those people with money invested in a futures account. Will one of the clearing firms announce that they lost $1 Billion in a pool of mortgages? Will the CTA you are invested in turn out to be borrowing money to leverage up his returns on pools of mortgages? The quick answers to those questions are maybe, and no.

But there are several important characteristics of a futures account which are important to understand in order to see how and why your futures account is safe from these specific types of threats.

Transparency (see what's happening):

The first good thing to know is that you are not invested in a pool of mortgages. While that may seem overly obvious for many people, it is an important aspect of a futures account that you can see what your invested in on a daily basis. The questions of "How is my investment doing" and "What am I investing in" are called transparency - the ability to see your positions and profit or loss on a daily basis.

Unlike other alternative investments in instruments such as private equity deals or hedge funds, where positions are not known and performance is reported monthly or quarterly - a futures based investment in an individually managed account has complete position level transparency. That means you see everything, right down to each trade, each day. No surprise collapses from owning a pool of sub-prime mortgages as many hedge fund investors were left with.

Further - you know that anything you are trading is being done on a regulated futures exchange, which posts the last traded price for the market throughout the day, and guarantees the other side of the trade. So there is no risk that your position is not being fairly priced. Your positions are marked to market every day - whether its good or bad. Your account sees the open trade gain or loss immediately.

Segregated Accounts (your money, not the clearing firms)

The chance of a firm going out of business or closing its doors is always present, unfortunately. But the industry has been set up to combat the dangers to your account should your clearing firm (or brokerage firm for that matter) go out of business. The secret to protecting your money is that investment accounts are held in segregated accounts. This small distinction may seem obvious, but it is of the greatest importance - as it means it is not an asset of the firm you are dealing with (the clearing firm or your brokerage firm), rather an asset of yours.

The Commodity Exchange Act requires that funds deposited by a customer with an FCM be maintained in a "segregated" account for the exclusive benefit of the depositing customer. The term "segregated" refers to separating the funds of all the customers (treated as a class) from the FCM's own funds (sometimes referred to as "proprietary" funds) which the FCM uses in its own operations.

So that if a firm does go bankrupt, or physically blow up in a 9/11 type event, etc. - there is no claim on your money. If Attain goes bankrupt, we can not pay our debts with your money. The same with any clearing firm. They have no access to your money except to post it as margin on the exchange when you place a trade.

Where things get sticky, and where 99% of the problems are in the banking, brokerage, and financial industry is when your money is not in a segregated account. When you write a check to John's commodity fund, for example - the money is then under control of the manager - not you, and it is not in a segregated account. This small point is the most important point in understanding how all this works.

Generally, in such circumstances, cash in customer accounts is promptly transferred, along with the customers' open positions, to a solvent FCM even before a trustee is appointed to administer the bankruptcy. After such a transfer takes place, the customer is free to transfer his funds and open positions to the FCM of his choice.

The beauty of the segregated accounts protection, is that it was actually put to the test at the end of 2005, when one of the largest clearing firms in the world, Refco, went bankrupt in the matter of weeks. Attain had hundreds of clients with accounts at Refco, and not one of them lost money or was negatively impacted in a any way (maybe a few nervous moments watching the news). In short, the system worked as it was supposed to, on a grand scale.

Too Big to Fail?

Beyond the segregated accounts, a more powerful motive for protecting client assets is the responsibility of all involved to keep the system running. If a clearing member blew a couple hundred million dollars betting on short S&P options - and was forced to sell its seat, liquidate all assets, etc - and threaten in any way individual client assets, either the US government or the other clearing members would step in.

This is because the system requires two parties to be successful. If party A has $100 MM in profits on its books due to taking the other side of trades Party B initiated - and Party B couldn't cover 100% of that loss - then Party A would in fact have lost $100 MM, in turn making them default on other monies it owed, in turn causing other defaults, etc.

The clearing firm's actually guarantee the other side of all trades, and don't do so just out of the kindness of their hearts. They actually make each clearing firm post margin each day and settle up for their trading each day. So the money needed for "trading" is all at the exchange each day - guaranteeing that the other side of the trade will be made good.

This threat of the counterparty going bankrupt was the threat posed by the failing hedge fund Long Term Capital Management in 1999. Those were not regulated futures positions, thus not guaranteed, but the Fed invited the major banks to meet, and they came up with a multi-billion bail out package so that the whole system would not fall apart.

The following link to the National Futures Association lays out some more information on the safety and protection afforded futures based investment accounts:

http://www.nfa.futures.org/investor/Storybehind.asp