In a sign of the times, a few readers have contacted me over the past months asking what you’re supposed to do when your brokerage account balance exceeds $500,000 and the amount of your account is no longer covered by SIPC insurance.
As many of you know, the federal government is the first backstop against institutional failure. You got $75,000 in a bank account, and the bank goes under? No problem. You’re covered up to at least $250,000. Got $125,000 sitting in a credit union somewhere? No problem. NCUA insurance has you covered for at least $250,000. And because credit unions have no shareholders, the risk of institutional failure is minimal because the credit union is run to benefit the lives of depositors and other customers whereas banks have to charge higher fees to make a profit for shareholders. Plus, there is the prospect of demutualization. Every now and then, a credit union decides to convert into a publicly traded company, and when it happens, the depositors become the public shareholders.
It happened at Standard Life where suddenly everyone got 185 shares of their financial institution as it transitioned to becoming a publicly traded company, plus additional shares if you had a large balance or had been a client for a long time. The demutualization of credit unions is a very rare process—it might happen to one credit union in your city during the course of your lifetime—but given that credit unions tend to offer a better banking experience anyway, you might as well go through life collecting free lottery tickets.
This kind of coverage extends to brokerage accounts as well. When you open an account at Schwab, ETrade, Scottrade, Fidelity, T. Rowe Price, Vanguard, or any other provider, you receive at least $500,000 in insurance coverage for your investments. If you had accumulated 10,000 shares of Coca-Cola over your lifetime and owned it solo in a brokerage account, there is no risk of permanent loss if the brokerage itself goes under. Those 10,000 shares would have a market value somewhere around $410,000-$420,000, and you would be well covered by the SIPC insurance provided by the U.S. government.
The more interesting thing is figuring what kind of coverage you have if you own over $500,000 in stocks and bonds with an institution and that institution experiences some kind of insolvency. The answer: It varies.
If you find your account balance exceeding a $500,000 threshold, the first thing you should do is contact your brokerage house or bank to figure out what kind of extended insurance you receive beyond the $500,000 limit. If your account is with, say, Charles Schwab*, a private insurance agreement exists with Lloyd’s of London and other English insurers to cover each client account up to $150 million.
So if you owned 100% of the publicly traded stock in Pulaski Bank and kept it public for some reason, you would receive the full $150 million value for you 12,000,000 shares if Charles Schwab went bankrupt. The only catch is that the extended insurance is meant to cover securities (not cash), and the terms of the agreement reflect that. The extended insurance only covers you for $1.15 million in cash.
If you had a Schwab account with 6,000,000 shares of PULB stock and $75 million in cash, you’d be in deep trouble. The $75 million in stock would be covered, but your cash position would only be covered to the $1.15 million mark so you’d experience a loss of $73.85 million from what the extended insurance arrangement did not cover.
This trend emerged as a way to keep wealthy heirs invested with places like Schwab so they can live off their dividends and have the peace of mind that their inheritance will not disappear. That’s what Walt Disney did—he set up $20 million trusts for each of his heirs that sit on a Schwab account and are managed through the Disney foundation so his second-and-third generation heirs can collect $200,000 in cash dividends each year and go about their lives.
If you were financially sophisticated and ran a business that involved significant amounts of cash coming in each month, you would want to set up a zero balance global custody account (most likely with a large bank). You would go to a place like Northern Trust and arrange to have most of your liquidity put in short-term U.S. treasuries while holding your securities investments in your name outright to remove the possibility of getting rocked by bank failure. Of course, the risk of Nothern Trust going bankrupt is virtually nil—it administered the estate of President Garfield and remains well-capitalized and highly profitable to this day—but the account wrappings prevent you from being exposed to institutional risk.
What would happen is this—the actual investments like 15,000 Hershey shares or 30,000 Coca-Cola shares would be directly registered in your name, and the failure of the bank would not change this fact. You can move along your way to the next bank in the event of insolvency. And your cash management would work as follows—you’d have an account with, say, $2,000,000 tied up in T-Bills paying 0.5% interest or something like that. Your zero account balance would show up zero, but your card purchases would be guaranteed by the bank. You go on a shopping spree—buy World Series tickets for $5,000 each—and the bank itself actually backs up the transaction making your zero account balance -$10,000. Then, at the end of the day, $10,000 in short-term bonds would be sold, and your bond balance would become $1,990,000 while your account would have $0. Hence the term, zero balance global custody.
For someone that has a large balance with an institution like Charles Schwab, you might think you merely passed the buck along the Lloyd’s of London without receiving a fully satisfactory solution. After all, if something as mighty as Charles Schwab were to go done, who is to say that Lloyd’s of London wouldn’t encounter comparable trouble that would make it unable to pay out the claims?
By choosing a British insurer, Charles Schwab sought to mitigate the risk of an American financial crisis by hoping Britain wouldn’t simultaneously be encountering financial calamity. There is also the fact that it is an iconic institution in its own right, and would potentially receive a bailout from the British government just like General Electric did during the 2008 financial crisis in the United States. The rich history of tremendous asset size would merit saving.
But, if there were no bailouts, it would ultimately rest in the hands of state regulators. State governments have wildly enormous power to regulate insurance companies compared to its power of banks which tends to be the bailiwick of the U.S. federal government. Each state sets up a fund to cover the failure of insurance companies, so a wealthy individual’s coverage trail would be: Schwab failure leads to SIPC insurance, and beyond that Lloyd’s of London coverage, and beyond that, the rainy day coverage fund created by the state government. It could lead to a situation where a California resident receives a wildly disproportionate potential outcome than, say, a Wyoming resident.
But that is just an analysis of the law as it currently exists. If things truly got so bad that these types of brokerage houses were experiencing trouble, the government modifications would likely be enormous if the 2008-2009 crisis is any indication of how things will play out next time. This is hard to analyze pre-emptively because the powers-that-be tend to adopt an attitude of making up the rules as they go when the liquidity crises become uncharacteristically deep.
If these things truly concern you, should do what Walt Disney, John Rockefeller, and Sam Walton did in their early days—divide their assets among four of five institutions to increase coverage and reduce wipeout risk. If you wanted virtually nil risk, you would open zero balance global custody accounts with each so that you owned the securities, bonds, and cash assets directly and removed the consequences of banking institution failure from your life entirely. For what it’s worth, this is what Warren Buffett did: he went running to Citigroup to set up zero balance global custody accounts as soon as he was preparing to purchase National Indemnity for $8.6 million in 1967.
*= If your account is with Charles Schwab, you should keep in mind that the bank is one of the healthiest mega-institutions on the globe. It is sitting on $32 billion in cash. It has no pension plan, it only has $120 million in leases outstanding related its trading platform technology, and it still made over $500 million in annual profits during the worst of the recession. The fact that the company remained profitable during one of the three worst economic periods since the Civil War should have some reassurance value to you.