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How Counter Party Risk affects your mutual fund investment.

This can be summed up in one word, albeit dramatically: Lehman. The demise of this financial institution was a shock to the economy in 2008 that still reverberates. What Lehman did is at the heart of counter party risk. As we continue our look at risk in mutual funds, this type of risk may not be thing of the past. Why? Some feel that the markets would lock-up without it.

So what is counter party risk?

In a mutual fund, the manager may buy a security that is a repurchase agreement whereby a seller agrees to a price for security and the commitment that they will repurchase that security at set price and time. The risk here is you are never quite sure what kind of commitment the other party has with other investors. This creates the illusion that, should the other party default, the investors standing in line will be you alone.

But sometimes, the other party resells the same agreement to many investors, making the line longer should problems occur and leaving your position in line in question.

Jeff Miller of Seeking Alpha describes the activity in terms of a gamble on a sporting event. He wrote this about Lehman in September of 2008.

"Let us start with an example that everyone can understand." He begins. And because the correlation between this kind of investing and the world of sport's betting, he asks you to, "Suppose that you occasionally make a football bet (completely illegal) with an online sports betting service or a local provider of such services. Since you are a recreational player, your normal unit is $100, an amount less than tickets to a local sports event. If you lose, you have to sacrifice some fun. If you win, you can have more fun. Either way it is not a life-changing event.

"Let us further suppose that you have a friend who is a rabid fan of some team with uncertain potential." This team with uncertain potential represents the other party's belief in the investment they are offering your fund manager. "Your friend," Mr. Miller continues, "wants to bet on the game. He does not have a place to bet, and he wants to bet with you. Let us suppose that he offers a bet of $1000 and is willing to lay 3 1/2 points."

For those of you who might not know what laying off means, the bet that was placed with the bookmaker was bet again with other bookmakers as a way to hedge against losses.

Mr. Miller writes, "Since you can "lay off" this action with your dependable source while giving only 2 points, you take the bet." Your friend in other words was willing to offer you a greater percentage of the win should you place the bet with him, more than your bookmaker offered when you place "the bet" with him. "If you lose to your friend, you collect from the other party. If you win from your friend, you collect from your source. If the result if the game is your friend's team winning by 3, you collect on both bets, making $2000. If you win from the friend and lose to your illegal source, you pay the "juice" and lose $100, your normal risk amount. You decide to bet with your friend and lay off the action, locking in a low-risk position with considerable upside." You can see that this appears to be win-win proposition and why, when there is a an opportunity to make easy money, this type of transaction can very tempting for fund managers looking to boost returns. And we all know returns are what bait future investors and keep current shareholders happy.

But there are flipside risks to consider. Mr. Mill adds that, "The risk in this totally illegal maneuver relates to the counter parties. Let us suppose that your friend's team loses big. You need to collect from him to pay off the other side. Finally, let us suppose that you later learn that your friend has made ten such bets, and you are standing in line to collect. Meanwhile, your obligations are instantly collectible."

Some funds paid big for this type of gamble and if I know Wall Street, this type of activity will not cease entirely. Remember, the markets need assurances and above all, risks in order to generate money for investors. This is not saying you should ignore the opportunities that risks offer but instead, measure them carefully into your goals.

Next up: derivative risks