So far, 2008 has seen the failure of 11 banks and the collapse of two major brokerage firms. With all the turmoil in the financial markets, a lot of people are asking themselves, "How safe is my money?" I think what they are really asking is "How safe is my custodian?"
Before I go any further, I want to assure Willow Ridge investors that we are watching our custodians very carefully. Generally our client accounts are custodied at Fidelity Institutional Brokerage or at Schwab Institutional. Both firms are very well managed and both steer clear of the dangerous, risk-taking shoals upon which the Wall Street firms have foundered.
A custodian firm has the responsibility for keeping your assets safe. Safety in this sense, does not refer to the market performance of a particular asset, rather it means the actual, physical safety of the assets in your account. When we consider safety from a custodial standpoint, we are looking for answers to questions such as: Is the asset really in my account? Did my trades settle properly? Can I believe my monthly account statement? Usually, investors tend to take these types of things for granted. However, when a custodian fails (like Bear or Lehman or Merrill Lynch), these questions suddenly become much more interesting.
In general there are two type of custodians: banks and brokerage firms, though in recent years the boundaries between these types of firms have blurred. Bank of America's buyout of Merrill Lynch will further blur the boundaries. In any case, let's consider the kinds of risks associated with each type of custodian and the protections available to help mitigate the risks.
Banks & the FDIC
Banks are the most common type of custodian. Most people have checking accounts or savings accounts. Many also have certificates of deposit. When an investor deposits money into these types of accounts, the depositor's money becomes part of the bank's overall capital base. In effect, the investor is lending the deposited money to the bank. The bank's ability to repay the deposits depends on the financial stability of the bank itself and the confidence of depositors in the bank.
In order to bolster depositor confidence, Congress created the Federal Deposit Insurance Corporation or FDIC. The FDIC insures bank deposits up to $100,000, but there are some nuances to this insurance that investors need to understand.
The insurance covers only deposit products (checking, savings, or CDs). It does not cover non-deposit investment accounts (annuities, mutual funds, stocks, bonds, municipal bonds, government bonds, etc.) offered by many banks today.
Insurance coverage is based on the overall amount deposited by a particular investor in a particular institution.
Deposits maintained in different categories of legal ownership by the same investor are counted separately. For example, if an investor has one account titled only in her name and another account titled jointly with her husband, each account would be eligible for $100,000 coverage.
If the bank acts as trustee for a self-directed retirement plan (IRA, Keogh or pension or profit-sharing plan), coverage may be increased to $250,000 for that particular account.
Coverage for business accounts is also limited to $100,000 but the terms are more restrictive. You cannot increase business account coverage by setting up accounts with different categories of legal ownership.
As long as you stay within the FDIC limits, you can be confident that your deposits are secured. Click here for more information on FDIC insurance.
Brokerage firms as custodians & the SIPC
Brokerage firms are the most common custodians for non-deposit investments. Unlike banks, when money is put into a brokerage account, it is kept separate from the assets of the brokerage firm. The brokerage firm cannot take the money. It is always there should you wish to withdraw it or invest it in some way. These firms carry two forms of insurance for client accounts.
The first form is issued by an entity called the Security Investor Protection Corporation or SIPC. The SIPC covers investors in the event a securities firm fails and assets are missing from accounts. It does not compensate for losses due to market action or fraud. Those are risks borne solely by the investor. The SIPC covers the first $500,00 for accounts held in each form of legal ownership.
In addition, most brokerage firms carry supplemental insurance well in excess of the SIPC coverage amounts. Charles Schwab, for example, has private insurance from Lloyds of London to cover up to $150 million per customer including $1 million in cash up to an aggregate payout of securities and cash of $600 million. As with SIPC coverage, supplemental insurance does not protect investors against market losses. It is simply a backstop against dislocations and missing assets that might occur if a brokerage firm went under.