Monday, September 14, 2009

Who Really Owns Your Investments?

Main Street’s Lessons from September 15:
Who Really Owns Your Investments?
By David Smith
September is a month of tremendous lessons for Americans.

Most of us remember the events of September 11, 2001, and hopefully we haven’t forgotten the lessons of those events.

But who remembers the big events of September 15, 2008, and what, if anything, have we learned from them?

It was on this day that the global brokerage firm Lehman Brothers filed for chapter 11 bankruptcy protection. This filing marked the largest bankruptcy in U.S. history, and was also a central event that helped bring about an enormous stock market plunge, and a much broader financial crisis. Today, the global economy is still struggling to recover from these events.

As I’m sure was true for most Americans, the Lehman bankruptcy was personally very troubling to me. Yet it was even more disconcerting to me on a professional level, because as a Registered Investment Advisor, I realized at the time that I did not clearly understand the risks to my client’s money in the event of a brokerage firm collapsing.
A chain is no stronger than its weakest link
After that event, I joined forces with a colleague and began researching brokerage firm risks and systemic failure. This was a new professional focus for me, because for 22 years I had viewed my job as primarily one of identifying attractive investments and managing portfolios, to accomplish the goals of my respective clients.

But after September 15 of last year, my job description expanded out of necessity. Given Lehman’s failure, I realized that I absolutely had to begin understanding the structural risks in our financial system, especially as they related to the investments of both individuals and foundations.

My research of the Lehman failure identified four points of weakness that I later found present in every major brokerage firm I reviewed. They are as follows: 1. Street Name or Firm Name - Brokerage firms usually hold their customers’ investments in the “Brokerage Firm’s Name,” not the customer’s name. 2. Rehypothocation or "Pawning" - Brokerage firms frequently “pawn” their clients’ investments, and use the borrowed money as operating capital to conduct the firm’s business. 3. Derivatives - Much has been said and written about derivatives in the past many months. Rest assured, they are a black hole in our financial system today. Derivatives are basically bets, and they are what caused Lehman to fail, as well as the Merrill Lynch and Bear Sterns melt downs. 4. False safety valve of SIPC (Securities Investor’s Protection Corporation) – They have made promises to millions of investors, yet SIPC currently has the ability to fulfill its full $500,000 promise to less than 5,000 investors.

While all of these weaknesses are serious and present certain vulnerabilities, the most important one to address is weakness number one, the problem of Street Name or Firm Name. This should be the big lesson of September 15th 2008.

If you have a brokerage account, you get a statement every month or quarter. Your name is on the statement, but your Brokerage Firm’s name is on your investments.

Having your Brokerage Firm’s name on your investments is like you buying a house and using a real estate attorney, to act both as your real estate agent and to draft legal documents. Your attorney tells you that it is quicker and less expensive to close the deal if he puts your new home in his name, and that you will have a separate contract between you and he, that says you are the beneficial owner.

That could work out fine, but what happens if your attorney loses 5 million dollars on a big real estate deal that went bad? You got it…bye bye house. Sure you can sue him and try to force him to make good with the contract. But how can he pay you back? He has just been wiped out. Everything that was in his name is liquidated…including your house, it is gone.

It is much the same, when you hold your investments at a brokerage firm in Street Name. Had the Federal Reserve not come in with Billions of dollars to stabilize the bankruptcy at Lehman, their American customers would have been crushed. I am not talking about their investments declining in value because the market tanked. I am talking about Lehman’s customers getting back their investments…you know, the ones that were showing up on their statements. The European Lehman customers did not get bailed out by the FED and they have still not gotten their investments back according to the last report I read in the 2nd quarter.

Don’t get complacent. The FED and US Treasury have limited abilities to bail out Brokerage Firms in the future. So don’t let your investments be held in Street Name.

Last but not least, if the brokerage firm that holds your investments fails, and they hold them in Street Name (likely over 99% of the time), SIPC does not treat those holdings as being Customer Name Securities, which means SIPC may move your investments into “The Fund of Customer Property” and from there subtract all the liabilities of the firm and then on a pro-rata basis pay what remains out to customers. If you get to that point, you hope SIPC will be able to stand up to its promises, but that is number 4, and that is a story for another day.

A chain is no stronger than its weakest link. “Street Name” is one link that we should all replace.

David Smith is Founder and Chief Investment Officer of
Smith Investment Management, in Georgia.

Email David Smith or Visit his website

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Jasper I said...

Wow! That's all I can say......Wow!

I'm going to be looking into my investments TODAY!

Ray said...

I'm in the same business out here on the Left coast.

David Smith--you have opened my eyes.

Tom T said...

Good stuff.

I hope I'm not too late!

Fred E. said...

We need morw investing reports like thid.