Financial Institutions- Is Your Money Safe?
The headlines have been full of bank troubles and failures like Indy Mac. The FDIC recently stepped in to save Indy Mac depositors in July and this action is expected to cost the FDIC some $4 to $8 billion. This is in addition to the approximately $1.2 billion in other FDIC bank rescues so far in 2008. Given such news, it is timely to discuss how assets are protected and why you should not worry about it.
There are two types of financial institutions where individuals hold accounts- banks and brokerage firms. Let’s start with banks as the “member FDIC” tagline is quite familiar to all of us. The FDIC or Federal Deposit Insurance Corporation was created in 1933 as a response to the Depression’s bank failures. It insures deposits to $100,000. If for example, you have a savings or checking account at Bank of America or a local bank and they go out of business, you will automatically be returned all deposits in full up to $100,000 with no questions asked and usually within a day or so. If you had more than $100,000 at the failed bank, you would eventually recover some portion of the rest depending on how much the bank actually lost and how the accounts were titled or registered (the FDIC has a calculator on its website to help maximize coverage). Generally, not even uninsured depositors (over $100,000) lose money as regulators are able to sell the bank’s customers to another bank to make customers whole. This is why the FDIC steps in so quickly when regulators determine a bank is failing- to prevent additional losses. In fact, you probably are unaware that the worst period for bank failures was not during the Great Depression, but rather from 1980 to 1994. Banks did not have the FDIC during the Depression which is why images of people losing their life savings resonate with us today. We don’t recall depositors lining up outside banks during the early 1990’s because the FDIC kept the depositors safe.
Brokerages like Schwab, Fidelity, eTrade and Merrill Lynch are not covered by FDIC insurance. Instead they are protected by SIPC or Securities Investors Protection Corporation which was founded in the 1970. SIPC provides protection up to $500,000 in securities including $100,000 in cash. Obviously, it is not practical to always have less than $500,000 at a brokerage. Indeed, the target customer of most brokerages maintains accounts much larger than this threshold. Are these assets in danger? The short answer is no. To understand why brokerages do not face the same threat of loss, it is important to understand why FDIC protection is necessary at all.
When you open an account at a bank, your funds are pooled with other depositors and effectively become an asset of the bank. The bank promises to return your money on demand with interest and in exchange is able to invest those funds in higher yielding assets. Just like your investments, the value of a bank’s assets will fluctuate and sometimes result in losses to the bank, but not FDIC insured depositors. Very few banks have significant trouble with losses because their assets are generally diversified, high quality investments while they also maintain capital on hand to absorb the losses. In fact, banks are highly regulated and must maintain certain levels of capital by law.
Occasionally a bank may be too aggressive with the assets it holds which means that the assets can generate larger losses than the bank’s capital cushion can handle (i.e. too risky). In the case of IndyMac and a few others, some of those assets (like sub-prime mortgage securities) were thought to be relatively safe but turned out to be rotten. When a bank’s assets shrink because of losses, their liabilities to the depositors still remain whole. If a bank’s assets deteriorate to a point where liabilities exceed assets, they technically become insolvent and any assets (including deposits) are available to pay creditors (creditors include the depositors). Put another way, banks profit by investing your money while promising to return it, whereas brokers make money by earning fees for services like trading while only holding your assets in custody for you. Keep in mind that only a very few banks will make aggressive enough investments at just the wrong time to run into real trouble- which is where the FDIC comes in. The vast majority of banks will simply be less profitable for a time, but they will remain perfectly sound.
Funds and investments in a brokerage account are very different from those in a bank account. At a brokerage, you are not lending funds to the broker. The broker does not accept the gains, losses and income. Rather, the account owner accepts the investment results. As a result of this arrangement, the assets are “segregated” from the firm’s actual funds and not available to the firm’s creditors. So if a broker runs into financial trouble, customer assets are protected from the broker’s creditors by virtue of not being an asset of the broker. In fact, when Bear Stearns ran into trouble earlier this year, no customers were in danger of losing funds.
So what is SIPC for if assets are protected from the broker’s creditors? SIPC exists to protect a broker’s customers in case securities go missing. If the largest broker failed, not a single customer would lose a penny because customer assets are protected through segregation, but if someone in the firm actually managed to defraud the accountants, several different regulators, the compliance officers and the auditors, then SIPC would step in to make customers whole up to the stated limits mentioned above. Many brokers also hold insurance above the SIPC limits, but even more important is that since 1971 there have been 625,100 claims to SIPC. Of these, only 349 claims were not made 100% whole representing less than 0.06% of claims. Let me present these phenomenal results another way:
- Total claims: 625,100
- Claims not totally satisfied (less 100% of money returned): 349 or <0.06%
- Total value of claims at failed brokers: $15.7 billion
- Total value of assets at failed brokers: $15.4 billion
- Total value of SIPC protection provided: $323 million
- Total value of funds not recovered by customers: $47 million out of $15.7 billion
- Total amount of assets at failed brokers returned to customers with claims: 99.7%
The $47 million which was never recovered or provided by SIPC was lost by 349 customers. Some quick math indicates this amounts to about $135,000 per customer. Now $135,000 is of course a significant amount of money, but the customers who lost these funds had very large accounts relative to the SIPC protection. I estimate that these unfortunate few lost about 10% of their accounts.
The President & CEO of SIPC recently pointed out that those 349 unsatisfied claims were before 1978 when protection was limited to $100,000 and paper securities were physically transferred between brokers settling accounts. Since the adoption of computers, securities rarely go unaccounted for as they might with a lost, miscounted or unaccounted for paper certificate.
Examining these odds another way: you would have be unlucky enough to have an account at a failed broker (rare) AND have a balance that far exceeded the protection AND securities would actually have to be missing despite regulator inspections (extremely rare) AND then the loss might be around 10% (not even close to a total loss). That is a lot of unlikely “Ifs” and “Ands”.
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