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Understanding The Letters That Protect Your Money (FDIC and SIPC)

By: John Pitlosh

By: John Pitlosh CFP®, MST

“And you can take it to the bank.” Most people would associate that statement as a guarantee or a solid promise that something will get done or something is safe. In my first month at Investor Solutions the question of concern on almost every client’s mind is “Can I take it to the Bank?” A once solid statement of guarantee has been flipped on its head and turned into a question. Never in a million years would I have guessed that the biggest cause for concern among our clients would be the safety of their bank and brokerage accounts, but in times like these it is both helpful and reassuring to review the backstops that are in place to protect our assets and analyze our own potential risks. When we see headline after headline about troubled financial companies it may seem like the only safe place for our money is under our mattress. In reality, it’s fear and ignorance that cause us to make the bad decisions that cost us money. Hopefully, this review of some of our systems financial safeguards will give you a better understanding of your own risks so that you protect your hard earned money and sleep a little better at night.

Headline – Washington Mutual the biggest bank failure in US history

Reality for the consumer – JPMorgan Chase acquires banking operations of Washington Mutual for $1.9 billion in a transaction facilitated by the FDIC. This transaction protects all the depositors (insured and uninsured) of Washington Mutual at no cost to the FDIC.

Headline – IndyMac one of the biggest bank failures in US history

Reality for the consumer – At the last estimate, there were about $541 million in customer accounts that weren’t insured. FDIC paid uninsured depositors an advance dividend equal to 50% of the uninsured amount and they will have to cross their fingers and hope for the best beyond that. Based on the preliminary analysis, the estimated cost to the FDIC for the resolution of IndyMac is between $4-8 billion.

Headline – Lehman Brothers files for bankruptcy

Reality for the consumer – As a control measure, brokerage firms are required to keep customer cash and securities separate from company accounts. When this segregation is executed as it is required, a large failure like that of Lehman Brothers should have no impact on the client’s account. The main issue that consumers end up having to deal with is the delayed ability to access their account assets as they are transferred to other firms.

FDIC (Federal Deposit Insurance Corporation)

The FDIC is an independent agency that was created by Congress to maintain the stability and public confidence in our banking system by insuring deposits, examining, and supervising financial institutions, and managing receiverships. Where the FDIC’s rubber hits the road in our daily lives is its role as the government sponsored backstop that insures the deposits at most of the banks we use, through the Depositors Insurance Fund (DIF). The amount of FDIC insurance coverage we have isn’t a straight forward process as the coverage varies depending on your account titling and type. FDIC insurance provides us a layering of coverage at each bank and this coverage can be multiplied by replicating the account titling at a separate FDIC insured bank.

Protect Yourself by Layering Your FDIC Coverage at Your Bank – While this doesn’t cover all the layers of coverage available to an individual, there are four main layers that most individuals can utilize in order to maximize the amount of insurance coverage that they are eligible to receive through the FDIC.

Individual Account Coverage – The first layer of coverage consists of all the individual FDIC eligible accounts that you have at one bank are covered up to $100,000.* (Doesn’t include Transfer On Death accounts i.e. TOD)

Individual IRA Account Coverage – The second layer of coverage consists of all your individual IRA accounts with one bank that are invested in FDIC insured assets. The amount of coverage available through your IRA accounts is $250,000.

Joint Account Coverage – The third layer of coverage available consists of all the joint accounts that you participate in at one bank. The amount of coverage available to your portion of all your joint accounts makes up another layer of $100,000.

Revocable Trust Accounts Coverage – Revocable Trust accounts consist of two types of accounts, informal and formal. The informal accounts consist of all the regular accounts that you have which transfer to your named beneficiaries at your death like a Transfer on Death (TOD) type of account. The formal version of a revocable trust account consists of all the accounts that you have that are titled and held in the name of your actual revocable trust document that you set up through your lawyer. The coverage for this layer is the sum of both your formal and informal revocable trust accounts. The coverage layer for revocable trust accounts was recently amended and is a little convoluted so if my explanation isn’t clear you should refer to the link on their website regarding the new rules.

(http://www.fdic.gov/news/news/press/2008/pr08086.html)

Under the revised rules, the coverage for revocable trust accounts will generally be based on the number of beneficiaries named in a depositor’s revocable trust accounts. The insurance limit will still be based on $100,000 per named beneficiary. For revocable trust account owners with more than $500,000 in such accounts naming more than five beneficiaries, the coverage is the greater of either $500,000 or the sum of all the named beneficiaries’ proportional interest in the trusts, limited to $100,000 per different beneficiary.

NCUA (National Credit Union Administration)

The National Credit Union Association, NCUA, was established by Congress in 1970 and its role as the backstop for the nation’s federally licensed credit unions is analogous to that of the FDIC. Their insurance fund, the National Credit Union Share Insurance Fund (NCUASIF), provides similar levels of coverage to that of the FDIC, but you should refer to their website as the coverage amounts are defined under the NCUA’s own rules and regulations, so there is no guarantee that their coverage will move in lock step with any changes that are made to FDIC coverage.

FDIC (Federal Deposit Insurance Corporation)

Analysis

When we look at the risks the FDIC addresses, we get a better view for where the risk really exists in the system and where regulation is critically important. When we give our money to a bank, they immediately take our money and leverage, loan, and reinvest it somewhere else in order to make a profit while still managing to pay you back some interest on your deposit. Because banks can and have gotten into all sorts of trouble with regard to how they invest and leverage your deposits throughout our history, they are highly regulated and our deposits require a public safe guard like FDIC insurance coverage in order to maintain consumer confidence and protect their deposits. If insurance like FDIC wasn’t available ,most people wouldn’t feel comfortable giving banks their money, as a total risk to our deposits would only be offset by the convenience of having a checkbook, an ATM card, and the ability to earn less than a percent on the money in our savings account. That said, if our banking system doesn’t have capital to lend, business doesn’t get done.

SIPC (Securities Investor Protection Corporation)

SIPC is an often misunderstood yet essential part of our financial safety net that protects investors by helping to maintain order in the world of brokerage accounts. While a number of federal, self-regulating, and state agencies deal with cases of investment fraud, SIPC’s focus is very narrow. SIPC was not chartered by Congress to combat fraud, instead the SIPC functions to free up investor assets when they get bogged down in a financially troubled or failing brokerage firm. When a brokerage firm is closed due to bankruptcy or other financial difficulties and customers are missing assets, the SIPC steps in, and works to return the customers’ cash, stock and other securities. Without SIPC, investors at financially troubled brokerage firms might lose their securities or money forever or wait for years while their assets are tied up in court. However, SIPC does have limits with regard to the types of assets that it will cover and to what amount it will extend the coverage to individuals. In addition, individuals must maintain records to verify claims if items are missing.

SIPC Covered Assets and Limits

Asset Coverage and Limits – SIPC coverage is extended to cash and securities, such as stocks and bonds, and it is not extended to commodities, futures contracts, unregistered fixed annuity contracts, or limited partnerships. You can contact the SIPC or your custodial firms directly to see exactly what assets in your account are covered. When verifying coverage through your custodian, make sure you get it in writing. Customers of failed brokerage firms are able to get back all of the covered securities that are already registered in their name or are in the process of being registered. After this first step, the firm’s remaining customer assets are then divided on a pro rata basis with the remaining funds being shared in proportion to the size of their respective claims. If sufficient funds are not available in the firm’s customer accounts to satisfy the claims within there remaining asset pool, then the reserve funds of SIPC are used to supplement the distribution, up to a ceiling of $500,000 per customer, including a maximum of $100,000 for cash claims. Additional funds may be available to satisfy the remainder of customer claims through excess insurance coverage purchased by the custodian or after the cost of liquidating the brokerage firm is taken into account. Like the FDIC, it is important that you are aware of the various layers of coverage as you may be able to gain more coverage at a firm by simply changing how the assets are registered or held.

Analysis

While the money we provide to a bank through our deposits is in a constant state of motion and the safety of our deposits are tied to the success or failure of the bank, our brokerage accounts operate in a much more secure environment that is analogous to a safety deposit box. From a regulatory standpoint, brokerage firms are set up so that investor assets are kept separate from the brokerage firm’s assets and they are not allowed to invest or leverage the assets inside the investors account.* As a result, the concern over bad investing, over-leveraging, and bad loans aren’t an issue from the very onset of the relationship. At the end of the day, all the investor assets are separated from those of the brokerage firm, so the success or failure of the firm shouldn’t have a direct impact on the security of your assets, unless fraud is part of the issue. When financial failure occurs because the company has experienced bad investment performance or other outside issues that lead to the catastrophic failure of the firm, the SIPC will step in, but it is essential that clients maintain accurate records.

The two main custodial risks that the contents of your brokerage account face are outright fraud from the custodian and the financial distress of the company that is holding on to your assets. As I have previously stated, the SIPC has a very narrow mandate and it is thinly capitalized, so the only issue that it is adequately equipped to handle is the restoration of investor assets from financially distressed and failing brokerage firms. As a result, it will not reimburse individuals for outright investor fraud, unless the assets go missing, but this issue can be minimized by utilizing large, reputable, and conservative investment custodians. While SIPC cannot save you from fraud or the bad results or your investments performance, it can ensure that the contents of your brokerage account remain intact and readily accessible, within the coverage limits, no matter what kind of financial difficulty your custodial institution is dealing with.

Conclusion

While it may seem like the world is ending when banks like Wachovia and Washington Mutual can disappear and investment firms like Lehman Brothers can collapse, at the end of the day it’s comforting to know that there is some kind of safety net in place when institutions fail. As long as there are taxpayers, the FDIC will most likely have access to the capital it needs to function as the backstop to the banking system. When you take a second look at the risk associated with your brokerage accounts, some common sense when choosing a custodian (bigger is better), the segregation of assets, along with the SIPC backstop of SIPC should help you sleep a little better at night.

***Given the level of concern regarding this topic, we wanted to get this information out to you as soon as possible, but keep in mind that there is pending legislation as part of the “Wall Street Bailout” that could have an effect on some or all of what I have written. As a result, I will be doing a supplement to this article if and when that legislation goes into effect.

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