I don’t want to add to the panic, but one thing that is getting little in the way of attention here is the question of whether investors should have investments in their name or street name. Many brokerage accounts are automatically opened as margin accounts, or with margin features, which means if a brokerage runs into trouble, you become just another creditor.
If you’re not willing to take that chance, one suggestion is to transfer your account to a custody-type account at a trust company or bank trust department.
That’s what Mike Offit did. As former head trader of commercial mortgage-backed securities and asset-backed securities for Goldman Sachs (GS), who also founded the Commercial Real Estate and Mortgage Group at Deutsche Bank (DB), he knows a thing or two about money and trading. He wrote me after reading a recent piece I did about auction-rate securities, which have snared individuals in their deep freeze. We’ve since gone back-and-forth on the phone and via email.
It started with this email to me:
For some reason, I’ve noticed that mentioning my former job (I was the head trader of CMBS and ABS at Goldman for several years, and founded the Commercial Real Estate and Mortgage Group at Deutsche Bank) seems to convince people I’m not completely without my faculties!
There is an aspect of the credit crisis, which I predicted in an article submitted to Fortune and the Journal about a year ago, that has yet to be a focus. The natural extension of the synchronous deleveraging of markets is the failure of banks and brokerage firms, something that was called a “Cassandra’s” vision a year ago, but the FDIC this week reported a spike in “problem institutions” and the giants like Citi (C) and Merrill (MER) are facing capital challenges that promise to intensify in coming months as a recession hits their profit drivers and further writedowns as margin calls and liquidations bring increasing pressure on portfolio assets.
I used to be paid an awful lot of money to look for and hedge against possible disasters. In my entire career, the only times I ever suffered were from failures to act on suspicions of catastrophic risk. It is relatively easy to protect against disaster without exposing yourself to disastrous losses in the event of good news!
The issue is simply this: Is your money truly safe in a bank or brokerage firm account?
I am somewhat amazed no publication has run this piece or at least made this point to readers who depend on the financial press to try to protect them from risks they don’t know about! Ask clients of Refco or MJK Clearing (both of which failed in good times) how they felt having their funds tied up for months or years, and consider the implications of such failures in a massively stressed environment without excess capacity to absorb losses.
In his piece, which has never been published anywhere, Mike wrote:
Contained in virtually every brokerage firm’s standard Account Agreement (generally a Margin Account) is a provision that allows your brokerage to register all your securities in street name, meaning their own. Every security you buy, even if you pay for it in full, might technically belong to your brokerage firm. It could be that all you really own is a claim on the firm for those stocks and bonds. When securities in your account are held in street name, says Eric Brunstad, Visiting Lecturer in Bankruptcy Law at Yale Law School, it’s really not your property. It’s like depositing money in a bank account. Your cash isn’t sitting in the vault in a box with your name on it. You are simply a creditor of the bank. Maybe you should have read the fine print, after all.
For many years, virtually all securities have been held and registered electronically. The elegantly-engraved paper certificates you might remember are largely historical curiosities. Rather, most securities have been dematerialized, and exist only on the electronic books of the issuer and an electronic depository house known as DTCC. The securities industry has promoted this practice of holding in street name as good for investors for a variety of reasons. They will tell you that it makes buying and selling much easier for you, collecting interest payments more timely and simple, and even protects you against the loss or theft of those nettlesome stock or bond certificates, while reducing the costs associated with transfers and deposits. These things are all true.
As is typical with most things brokerage firms and their regulators tell you, however, there is far more to this than meets the eye. In fact, when your securities are held in the name of your brokerage or bank, they, not you, have most the rights of ownership. The issuer corresponds only with them, and sends them interest and dividend payments, and the forms to vote on corporate issues.
The broker then passes these communications on to you, in the form of envelopes you likely never open or ignore. (Do you fill out every proxy vote request you receive from your brokerage in the mail?) If you don’t vote your proxy, by the way, your broker can cast those votes on some matters, or possibly lend the stock and the right to cast the votes to someone else (say a hedge fund making a takeover offer.) Basically it’s as when you didn’t vote in a Presidential election, your political party’s bosses got to cast your vote! Your broker can do a lot of far more nettlesome things with your securities than just vote, though.
THE FINE PRINT
Those fine print of an account agreement generally includes one clause that reads something like this:
All securities, commodities and other property held, carried or maintained by you in your possession in any of my accounts may be pledged and repledged by you from time to time, without notice to me, either separately or in common with other such securities, commodities and other property for any amount due in my accounts or for any greater amount, and you may do so without retaining in your possession or control for delivery a like amount of similar securities, commodities and/or other property. (Arvest Securities Account Agreement)
This means your broker, subject to SEC rules, can lend your stock (and charge a hefty fee) to short sellers, hedge funds, corporate raiders and buyout funds and possibly even give them voting rights and control for key periods, and not have offsetting collateral in house. In short, they can mine these vast holdings of other people’s securities for all sorts of fees and income — earnings that run into the billions every year. Your broker generally keeps all this money. As the Bear Stearns Clearing agreement puts it, “As a result of such activities…the Clearing Agent Group may receive and retain certain benefits to which you will not be entitled.”
And if a broker fails? Again, Mike:
If a brokerage were to be taken over by the Securities Investor Protection Corp (SIPC - the governing authority) for insolvency, says Brunstad, first, customer name securities are distributed back to their owners. Securities held in street name, (the vast majority) however, would likely be included in the pot of customer property, which is later distributed ratably to customers. This could make it difficult for you to recover all of your securities, in some instances possibly tying them up for several years, according to the U.S. General Accounting Office (GAO-03-811 , Report to Congress: (Securities Investor Protection, July 2003, pp. 23.)
There are some simple things you can do about this. At the very least, only maintain a Margin Account if you absolutely must borrow money against your securities. Otherwise, ask to open a Cash Account, and read the Agreement, being sure that you do not authorize your broker to use your holdings for any purposes you don’t like or don’t get paid for. Instruct your broker in writing to register your securities in your name whenever possible — and get an explanation of any issues or fees this might raise. But the safest bet is to set up a custodial account at a Trust Bank, and have your securities delivered and/or registered there. Securities held by trust banks for their customers are registered in the name of a separate nominee than the bank’s proprietary property at DTCC, and barring fraud or misappropriation, will not get caught up in a bank’s insolvency. The bank will manage the paperwork and charge a negotiable custodial fee. Some will do it for free provided you agree to do your securities business through them.
Just because something is a common practice doesn’t mean it’s a good idea. Paying attention to the account agreements you sign makes sense –and often times brokerage houses profit immensely from those small print details, while putting their clients at risk. While the regulatory and ratings agencies are supposed to exercise oversight in protecting investors from predatory or dangerous practices, too often they do so as a cure, rather than a preventative.
“But Mike,” I asked, “why not just have your broker put in your stocks in your name and not street name?”
Herb - You CAN NOT register the vast majority of securities in your own name. PERIOD.
You MUST use a nominee registered at DTCC. The difference between a brokerage’s account nominee and a bank custody-or trust-type account nominee is that the NOMINEE in the latter is ONLY USED for CUSTOMER property, and the institution is bound by law and contract not to use the securities so registered for any purpose. It is essentially a safekeeping nominee account. By keeping the customer property totally separate from bank property, it will not get caught up in any bank failure. Brokerages do not do this. Yes, if you have more money, you can negotiate your own deal (we did)… but anyone with a few bucks can open an account at Northern Trust or such and ask that his securities be held in a customer-only nominee name. Most will do it, I’m sure.
I know it’s hard to believe. An individual or company CAN NOT register the vast majority of securities in their own name. I went through this with at least 4 major brokerages, INCLUDING Goldman. They had written an agreement to do that for a friend of mine with over $125 million in their Asset Management division, and had to admit that they simply COULD NOT DO IT.
That’s all one man’s opinion, albeit one smart man’s. I’d like to keep the discussion going from people who know a thing or two about trust accounts versus brokerage accounts.