Controlling
Counterparty Risk
How country elevators can protect against the downside
By Paul Narduzzo, Executive Vice President
CoBank, Regional Agribusiness Banking Group
Editor’s note: Narduzzo oversees the financial services provided to
CoBank’s U.S. agricultural cooperative customers and the institutional
lending relationships with agricultural credit associations.
CoBank is a $58-billion cooperative bank that provides loans,
leases, export financing and other financial services to agribusinesses
and rural power, water and communications providers in all 50
states.
deal is a deal. But what happens if one of the
parties in that deal can’t uphold his or her
end of the bargain? In rural America, even in
the best of times, it can mean the difference
between a profitable season and financial ruin.
In today’s economic environment, businesses of all sizes
and across every sector of the economy have ample reason to
worry whether supply-chain partners can deliver on their
contracts. American agribusiness is not immune from
economic challenges, and now is a critical time for country
grain elevators — a linchpin of the U.S. grain handling and
grain marketing system — to evaluate their business
relationships and to take steps to protect themselves from
counterparty risk.
“Counterparty risk” is a term that has received a great deal
of media attention in recent months in relation to the
financial crisis that rocked Wall Street last year. At the most
basic level, one of the driving forces behind the credit crisis
was the failure of complex hedging strategies — used to
mitigate counterparty risk — employed by large banks and
insurance companies. The consequence: some of the most
storied names in the financial world were brought to their
knees and forced into bankruptcy or liquidation.
The concept of counterparty risk, however, is not limited
to Wall Street, and it isn’t new to the nation’s agribusiness
complex. During a commodity price run-up in the mid-
1990s, some country grain elevators experienced a string of
producer defaults. That specter reared its head again in
recent years as soaring commodity prices spurred fears that
some producers who locked in sale contracts before the
dramatic market run-up might walk away from contracts in
order to sell their corn, soybeans or wheat to another buyer
at a higher price.
Fortunately, those fears did not turn into reality in terms
of any kind of meaningful trend.
Situation for 2010
For the 2010 growing season, the situation has changed.
The national and global downturn has reduced demand for
some products produced by U.S. agribusiness, putting some
sectors of the agricultural industry under significant financialSituation for 2010
For the 2010 growing season, the situation has changed.
The national and global downturn has reduced demand for
some products produced by U.S. agribusiness, putting some
sectors of the agricultural industry under significant financial
stress. Commodity prices, while still volatile, have softened
dramatically from the record highs realized in 2008. Corn,
which peaked near the $8-per-bushel level, is now trading
between $3 and $4 per bushel. Wheat and soybean prices
have also retreated sharply.
As a result, the nature of counterparty risk in agribusiness
has been transformed as well. From our standpoint at
CoBank, as one of the largest financiers of grain in the
country, we believe the new counterparty risk for elevators is
on the selling side of the house.
The reality is that, in some cases, once-dependable
customers for country grain elevators are facing difficult
market conditions. Dealing with this new risk requires
managers and boards to shift their way of thinking and
employ available risk management strategies. In Cobank’s
view, grain elevators need to consider taking the following
steps:
- Grain elevators should consider limiting cash-sale
contracts. It can be a recipe for problems if a third-party
finds itself in a financial bind — or worse, bankruptcy —
and can’t live up to the contract. Instead, elevators should
consider using basis-sale contracts and maintaining a short
futures position, which will protect them from most of the
counterparty risk resulting from price swings. This is not a
new process for most country elevators.
Let’s say an elevator has a cash sale contract to deliver
corn in November for $5 per bushel. But there is a problem
in the industry of the third party, and that third party can’t
buy the corn from the elevator when it comes time for
delivery. For this example, let’s also assume the price of corn
has dropped to $3 a bushel at the delivery date. The elevator
may be able to sell the corn to someone else, but it’s going to
be at $3 a bushel, meaning the elevator will take a $2-perbushel
loss on the deal. That can have a big impact on a
country grain elevator’s balance sheet.
Under a basis-sale contract, an elevator and the thirdparty
buyer agree on the basis level — which is the difference
between the local cash price and the futures price for a
commodity on the Chicago Board of Trade. Let’s say the
agreed upon basis is negative 30 cents, with a cash price of $5
per bushel and the futures price at $5.30. Under this
scenario, the elevator would have a short futures position at
$5.30 per bushel.
Fast forward to delivery time. Just as in the first example,
let’s assume that demand has softened, and the spot price of
corn has dropped to $3 per bushel; the futures price is $3.30
per bushel, meaning the basis remains at negative 30 cents.
As the delivery date approaches, the elevator would exchange
its futures position with its counterparty, showing a $2-perbushel
gain from the futures contract in its margin account.
The elevator’s final cash sale price is established by the
combination of the price at which the futures contract was
exchanged ($3.30-per-bushel) plus the basis of negative 30
cents, which yields $3-per-bushel. The country grain elevator
got $2 per bushel from the futures contract — and therefore
maintained its $5-per bushel selling price.
Under such an example, if the counterparty were to back
out of the contract at the last minute, the elevator would be
OK. The elevator could turn around and sell to another
buyer at the spot price and still be made close to whole,
depending on the basis level at the time of the sale as well as
freight costs. Country elevators that are doing business with
any sector of the agribusiness industry — good or bad —
should strongly consider adopting this practice if they are not
doing so already today.
- Grain elevators need to know their customers. When
elevators sell to a third party and deliver the product, they
often receive most of the funds when the grain leaves on a
rail car, but some customers are given 10 days or longer to
pay. These credit terms, too, are a counterparty risk.
But how should an elevator decide which customers
should be required to pay cash upfront and who should be
given 10 days or longer to pay? A good practice is to require
all customers to fill out a standardized credit application.
Such forms require the customer to disclose basic business
information as well as more in-depth financial information,
such as whether they have been subject to any judgments,
collections or liens in the past. In addition, these forms
typically require the customer to disclose credit references,
including the name of their bank. As a matter of practice,
grain elevators should check those references thoroughly
before extending credit terms.
Additionally, elevators should take supplemental steps to
find out about the businesses they are selling to by keeping
an ear to the ground and talking to industry contacts to see if
there is any word on the street that might raise red flags.
Often, industry insiders have information that will not appear
on a credit application that may be pertinent to a decision
about extending credit to a customer.
Some economists predict that the economy may begin to
rebound in the next six to nine months, which would be good
news for U.S. agriculture and every other industry. But even
if stronger commodity prices do return as part of a broader
turn around, country grain elevators must continue to be
vigilant on the issue of counterparty risk. Employing
appropriate mitigation strategies will safeguard elevators
from the possibility that, one day, a deal might not be a deal.
