Investing Strategy - Part V

Excess SIPC

I haven't done a post on investing lately; so let's try to rectify that situation.

A few days ago, I noted an article that talked about three brokerage firms losing their excess SIPC insurance coverage. It was in a Quick Links post and I mentioned that it was very significant. I'm sure that some people were wondering what I was talking about and why it was so significant.

To understand why the loss of excess SIPC is so important, we first need to understand what SIPC is. SIPC is the brokerage equivalent of FDIC. But it doesn't work quite the same way.

FDIC ensures that your money in the bank will always be worth what it is. In other words, if the bank has your money invested in Treasuries that suddenly dive in value (without your knowledge, of course. If you tell them to put it in a money market account, you lose the FDIC protection), FDIC will ensure that your, say $5000, is still worth $5000. With FDIC, you cannot lose value.

Most people really think of FDIC as protection against the bank failing, and that is part of what it does. SIPC is insurance only against the failure of the brokerage firm. Let's assume you have an account at Joe's Discount Brokerage in which you have $50,000 in cash and $250,000 market value in various securities.

SIPC protects you in the event that Joe's goes bankrupt. Should that happen, SIPC will make sure that you receive back your $50,000 and the securities in the account - even if the assets of the firm are insufficient to return them to you. SIPC does not insure you against your investment in XYZ going down in value. In the above example, if the $250,000 is invested entirely in Joe's stock (say you owned 2500 shares @ $100.00 per share at one point) and Joe's goes bankrupt, SIPC will cover the $50,000 in cash and will return your 2500 shares of the now worthless Joe's stock. In other words, they do not protect against market movement.

But SIPC only covers up to $100,000 in cash and $500,000 in securities (and for SIPC purposes, money market funds are securities. Keep this in mind, as it is a very important distinction). Let's say that you've got $8 million dollars to invest. SIPC doesn't really mean much in the way of protection for you.

Many wealthy investors who run into this situation will open $500,000 accounts at multiple brokerage firms. They'll do it partially to protect their money with SIPC and then they'll also claim that it is to "acquire a broader range of research and opinion." It's an effective approach, but it creates investing inefficiencies and paperwork nightmares.

A few big firms figured this out and went and negotiated insurance coverage to cover the value of the securities in their accounts that were over the $500,000 SIPC limit. This was called "excess SIPC insurance." At some firms, it imposed a new limit at $100 million per person; the firm I was at - there was no limit, in theory they would have insured accounts over $1 billion in value.

Excess SIPC was a big selling point. I used to talk to folks with multi-millions in the market all the time and one of the easiest ways to close a sale was to ask them about the excess SIPC insurance they had at Joe's Corner Brokerage where their buddy was their broker. It was easy: point out the value of excess SIPC and then watch the money transfer over.

Now why would people feel so secure knowing that they had excess SIPC insurance on their accounts? Brokerage firm failures are relatively rare, after all. Part of the reason was the feeling of safety that the insurance provided. But it was the second factor that always seemed to play a bigger part.

Everyone knows that the insurance companies have become so risk averse lately that if they even think that you might make a claim, or even place a phone call to them, then they'll drop you like a hot potato. With the big brokerage firms, people believe that the potential excess SIPC liability is huge, so if the insurance companies are willing to cover a brokerage house, then it must be safe (we never said this, but the implication was always there).

But the insurance companies also know that they've been raking in huge premiums without any claim action on these excess SIPC policies so, barring a significant change in the risk, they aren't going to want to cancel the gravy train.

But they did. They cancelled several of the policies. Which tells me that the insurance companies have detected an increase in the degree of risk associated with writing these policies.

Chances are that no major brokerage firm is going to be going out of business any time soon. But still, this should be a major warning to investors to learn about your firm and take steps to protect yourself, if necessary. And don't forget about your 401k. Don't be afraid to stir things up with your benefits department if you've got a serious chunk of change sitting in your account. It's your money and no one else is going to watch out for it for you.