Call it two days that shook the options markets, a debacle that exposed a way of losing money in commodities that not even the most senior veterans of the trading pits knew existed.
The two days were March 18 and 19, and the brief run-up of $36 in the price of gold in that period started a chain of events that officials of Comex, the New York futures exchange where options on gold futures are traded, are still working 10-hour days to untangle.
It all started when Jeffrey Westheimer, a gold options trader who held with his wife and a partner what by all accounts was a grotesquely over-extended position, defaulted on a $26-million margin call--a demand from his broker for more cash to cover the sinking value of his options.
The Westheimers' failure, according to court papers and interviews with participants, provoked the subsequent default and collapse of his broker, Volume Investors Corp., a firm owned by one of Comex's board members. Volume was suspended from trading and placed in receivership March 21, by which time its 100 customers had discovered that their roughly $18 million in accounts were frozen.
The Comex Clearing Assn., the independent body that acts as a financial intermediary in all Comex trades, paid out $9 million of its own cash and seized $10 million of Volume customer funds on deposit because of the firm's default. Then, to recover its own costs, the clearing house liquidated the options and futures holdings of Volume's customer in what some traders say was a chaotic fire sale that cost innocent customers millions.
The commodity world's most senior experts say the Volume collapse and its aftermath are unique in demonstrating, much to everyone's surprise, that one customer's default can cost a firm's other, innocent customers their money.
The debacle comes at a sensitive moment for the options business and Comex, formally known as Commodity Exchange Inc. Commodity options were reluctantly legalized by the Commodity Futures Trading Commission, the federal watchdog of the futures industry, for a two-year pilot period that ends this year. If the Volume fiasco is not satisfactorily resolved by October, when hearings open on an extension, the case may loom large in the CFTC's deliberations.
Limit to Protection
The collapse may also give renewed life to proposals for an insurance fund for commodity customers like the Securities Investor Protection Corp. (SIPC), which insures traditional securities accounts. Says Andrea Corcoran, director of trading and markets at the CFTC: "This is an example of what happens when you don't have insurance explicitly aimed at protecting the customers."
The device designed to protect customers from losing money in the event of a commodity firm's failure is known as segregation. In the futures business, each firm must keep its customers' money segregated from its own, so that a failing firm doesn't face the temptation of misappropriating its clients' funds.
But each customer's money is not segregated from that of any other customer. So when the Comex clearing house moved against Volume to cover the Westheimers' missed margin call, it seized assets that belonged to all Volume's customers, not just the Westheimers.
"To that extent, there's an Achilles heel exposed here," says Philip M. Johnson, a New York commodities lawyer and former chairman of the Commodity Futures Trading Commission. "We've all thought of the system as protecting customers from (a failing) firm, not from each other. I don't know that there's any precedent for this."
"It really shocked a lot of people down here," says one options trader. "We figured the segregated funds were safe."
For now, Comex officials argue that the damage is slight. "I believe it's a blemish on the industry and Comex to a large extent," says Comex President Alan J. Brody. "On the other hand, I think the event has been blown into something larger than it is."
There are hints that Volume's customers will be made whole in a settlement in which the firm's owners and Comex will participate, although the exchange does not admit liability.
Faces Huge Deficit
But estimates of the real losses from the Volume collapse vary widely. One customer with a thriving options trade has been put entirely out of business.
"We had one account, only at Volume," says Ronny Apfel, a 24-year-old trader who, with a partner, had made $1.3 million in six months trading gold options. The account was seized by the clearing association and liquidated so haphazardly, Apfel says, that he lost all that money and faces an additional $1.7-million deficit. "They took everything. They put us out of business. All our trading capital is gone."
Another trader says he lost more than $100,000 when the clearing house ineptly liquidated positions he had painstakingly constructed to be risk-free. He adds that he knows of at least eight other Volume customers who lost $50,000 to $150,000 each, and 20 more who lost smaller sums.
At best the episode demonstrates the breakdown of Comex's self-policing apparatus, which theoretically ensures that a firm will prevent its customers from taking positions so risky that the firm itself is endangered. Also taking a beating is Comex's all-important clearing mechanism--the system by which a seller and buyer complete their transaction through the clearing house as intermediary. Options and futures contracts worth an average of more than $2.6 billion pass through the Comex Clearing Assn. every trading day--but the clearing house has no mechanism to determine the magnified impact on its member firms of a sharp move in market prices.
"No system could have prevented the default of the Westheimers," says Thomas Russo, another prominent commodities lawyer. "But a better monitoring system would have prevented customer losses."
What makes the Volume case particularly piquant is that its leading players, far from being peripheral operators--certainly a species that abundantly populates the commodity markets--were as close to pillars of the industry as one might find.
Volume's two principals were Owen J. Morrissey and Charles Federbush. Morrissey is one of the exchange's largest traders and Federbush is a member of its board of governors. The Westheimers are only slightly less prominent. Jeffrey Westheimer has traded futures for 15 years; his father was one of Comex's founders in 1933. Mrs. Westheimer has also been an active trader in the past. When she reapplied for membership on Comex a few years ago after giving up her seat, her sponsor was Owen Morrissey.
Now their relationship lacks warmth. "Morrissey and his partner are really victims in this transaction," says Fred Santo, Volume's attorney. Santo says the two Volume partners have lost a combined investment in their firm of nearly $4 million, and will probably have to ante up much more in a settlement with the Comex, clearing house, and Volume customers.
The Westheimers were known on the floor as traders with considerable assets. These include a Park Avenue co-op owned free and clear, and an estate in bucolic Purchase, N.Y., which they named Limit Downs, a play on a commodities term. The public knows the estate better as the former home of Herman Tarnower, the slain Scarsdale Diet doctor.
Westheimer was also known as a gold bear with a penchant for "writing call options", a practice that is profitable if gold is stable or falls in price but highly unprofitable if gold rises. The buyer of a call option gets the right to purchase the underlying asset, in this case a gold futures contract, at a set price within a set period. The seller, or writer, of the options faces the potential obligation to deliver that futures contract.
Most traders in Comex's gold ring apparently sensed that Westheimer had written the Comex limit of 4,000 call contracts. They did not know that his wife and partner also each had written the limit, meaning the Westheimer group had written an incredible 12,000 call options without protecting themselves against the enormous risk.
"I knew he was at the limit," says Warren Schwartz, a former vice chairman of the New York Mercantile Exchange who was trading gold options in the Comex gold ring as a Volume customer. "But I didn't know he had three limits. If I had known he had so much at Volume, I would have moved my account right out of there."
Westheimer, who with his wife declines to comment, may have been permitted to accumulate this huge position over the first three months of 1985 because a lull in the gold market had Comex, the clearing house, and Volume feeling complacent. But gold soared on March 18 and 19 amid a crisis affecting the Ohio savings and loan industry. It subsequently dropped back in price.
"It's been a very sleepy market for a very long time." Johnson says. "One thing traders do in this situation is write a lot of options." That is, they sell people the right to buy gold from them in the future at a price they think the metal is unlikely to reach. The trader pockets the premium, or option price, and forgets about the apparently slim risk of having to deliver gold if the price rises.
"There's no chance you'll have to deliver--or at least you don't think so," Johnson says.
Point of Dispute
Writing such options is not a particularly risky move if one also owns gold or gold futures to back them up. Westheimer did not own any gold, however; in commodities parlance, for the most part his options were "naked." With 12,000 options, he faced the potential of having to deliver 1.2 million ounces of gold. The $36 move in the gold market on those two fateful March days represented an adverse effect on Westheimer's position of $43.2 million.
One focus of dispute between Volume and the Westheimers involves the margin calls the firm made on the customers to cover the rapidly increasing value of the 12,000 call options that represented their commitments to other traders. Ultimately, the firm asked them to ante up $26 million, a figure the Westheimers could not conceivably raise. The Westheimers have denied they ever received the margin call.
Normally, a commodity firm would cover a customer's margin default by paying the clearing house from its own capital, recovering its cash by subsequently liquidating the customer's position. Volume only had $3.5 million in capital, however. Because Volume could not cover the margin call, the clearing house seized and later liquidated Volume's positions--or rather, those of all its customers.
The immediate result of all this was a flurry of lawsuits. During a hearing before U.S. District Judge Kevin T. Duffy on Comex's motion to freeze the Westheimers' assets, Westheimer projected from the stand the aura of being scarcely touched, let alone moved, as the market moved ferociously against him on March 18 and 19. From his testimony, one would have to conclude that the prospect of being obligated to pay out $42 million in gold left him positively serene.
As Comex's lawyer probed the state of mind of Westheimer, a mathematician, nuclear engineer, and experienced player of tournament bridge and backgammon, there was this exchange:
Question: "Did you calculate approximately how much the loss was you suffered (on March 19)?"
Q: "You made no attempt to calculate it?"
Q: "Even in your mind, just figure it out roughly?"
Q: "It's easy to figure it out, isn't it?"
Q: "And yet you made no attempt to figure it out?"
Remarked Judge Duffy, who earned his skeptic's stripes as New York enforcement chief of the Securities and Exchange Commission from 1969 to 1972: "Given the educational, personal, and professional backgrounds of both (Westheimers), I find completely unbelievable the testimony that they were only vaguely aware" of margin requirements.
The contrast between what the Westheimers remember as their internal composure and what others viewed as emotional mayhem is notable. Asked about a meeting with Morrissey and other officers of Volume at the firm's office late on March 19--a meeting that began with the couple traveling downtown from their Park Avenue co-op at 10 p.m. to discuss their deteriorating position and ended well after 1 a.m.--the Westheimers remember it as nothing special. Nobody mentioned, they said, that they owed Volume millions in margin. Judge Duffy found it remarkable that the couple would have him believe that "the only thing they discussed was the weather."
Morrissey, of course, remembered a different scene. "They said it was a disastrous situation they were in, there is no hope, it's beyond hope," he testified. "They just looked very upset and they screamed."
Although technically the missed margin calls apparently made Volume insolvent sometime on Wednesday, March 20, the firm was not suspended from trading and placed in receivership until the following day.
Still, traders with Volume accounts tell chilling stories of being unable to gain access to their positions from March 20 on. Perhaps the worst nightmare belongs to Flo-Arb Partners, the firm established by Ronny Apfel and his partner, Abraham "Ramy" Goldstein, 34, the holder of a Yale doctorate in economics.
Apfel and Goldstein formed Flo-Arb in late 1984 to make a market in Comex gold options--that is, to keep an inventory of options on hand to sell to other investors, such as a stock brokerage in the over-the-counter market. Working with capital put up by some limited partners, they say they had turned a profit of $1.3 million by early March, when they were Volume's biggest customers. Not only was that money tied up in options held in their Volume account, they say, the chaotic liquidation that followed Volume's suspension turned their profitable position into a $1.7-million loss.
On March 20, Owen Morrissey cornered Apfel on the trading floor to tell him the firm was having "problems" and he would have to immediately stop trading through his Volume account. A shocked Goldstein, frenetically trying to transfer Flo-Arb's option positions to another firm, ran across the street and barged into Volume's office. There, he recalls, he encountered Saul Dworkin, a Volume margin clerk, and demanded he transfer the accounts--"ex-pit" them, in futures talk.
Dworkin took Goldstein to an upstairs men's room where he checked under the stall doors before telling him the firm was basically insolvent: "Ramy," he said, "there's nothing here."
For the next three days, Goldstein and Apfel tried to have their positions transferred from Volume to another firm. Comex rules state the clearing house must "endeavor" to transfer accounts of innocent customers before liquidating positions of a failed member firm; in this case, the clearing house chose to liquidate everyone.
Another trader called the clearing house to emphasize that his positions had to be liquidated carefully to preserve their risk-free construction. He reached an association lawyer and warned him a liquidation could cause him substantial losses.
"He was totally unfeeling," the trader says. "He said, 'If you're a customer of Volume, consider that you have no more position. It's being liquidated.' He hung up on me."
Final Blood Bath
But clearing house officials say Volume's insolvency made it impossible to transfer any customer accounts, for at that point none was adequately capitalized because there was no margin money left in Volume's accounts.
The liquidation, traders say, was the final blood bath. "They want everybody to think this was an orderly liquidation," Apfel says. "This liquidation was brutal."
Apfel and others say the clearing house tried to dump so many options on the exchange at once it threw the market's delicate supply-and-demand balance out of whack. Flo-Arb and the Westheimer group, two of Volume's biggest customers, together held as much as 70% of the outstanding positions on some options: They were the market, and the wholesale liquidation of their positions was costly.
Word apparently got out on the Comex floor that the clearing house was holding something akin to a distress sale. Comex members left their own posts to join the throng at the gold ring.
"Strangers came over to buy like crazy," says trader Schwartz. "These were guys I'd never seen before." Some people think these interlopers were tipped off, about which the clearing house will not comment.
"These liquidations did not disrupt the market on the days they took place," says the clearing house's attorney, Stephen Selig. "But whether people knew it was coming, I can't tell you."
What concerns some traders now is that any settlement will not cover trading losses they suffered from the liquidation--only whatever cash is left in their Volume accounts. Comex's Brody, questioning whether any Volume customer is strictly "innocent," argues this is as it should be.
"The customer who wants to be made whole to the point before this happened is not realistic," he says. "For better or worse, he had his funds at a firm that was mismanaged or misjudged the Westheimers. He could have done business with someone else."