By: John Pitlosh CFP®, MST
I find it difficult to write an update to my previous article while the massive thuds from current events are dropping all around us. The variety of pundit commentary and the lack of substance on both ends of the spectrum seem to be leading most people into a state of financial bi-polar disorder. The answer always seems to be somewhere in the middle, so I will attempt to put some of the headlines in perspective while giving you a link to the source. After I have given you my take on some of the major current events, I will move on to the update of my previous article, and I will attempt a conclusion that will try to put all this “stuff” in perspective.
What a difference a month makes… When I was writing my initial article, events seemed to be changing on an almost daily basis and the uncertainty surrounding the failure of financial institutions and the responsibilities of government to step in was unclear. When the government stepped in to save Bear Stearns and AIG (twice), but let Lehman Brothers fail, understanding government’s role and the predictability in which it will act was not all that clear. While it is still a one in a million guess to understand what measures or instruments our government will use to solve a particular problem, it is abundantly clear that if a problem is big enough, failure is not an option. In hindsight, I believe the government would have liked to stepp in to save Lehman, but the political will coming from “Main Street” just wasn’t large enough to save ANOTHER “Wall Street” Firm. In the end, it is readily apparent that the defined role for the government in the financial system is to provide a stable, transparent, and predictable environment for business. While a lot of you have been in a black out mode hunkered down in your bomb shelters, and who can blame you, hopefully this article will get you up to date.
Headline – AIG’s New Deal: Feds Ease Loan Terms, Provide Capital.
My Headline – “Too Big to Fail”
What Happened – AIG gets a $40 billion infusion of capital and a subsequent restructuring of their credit from $85 billion down to $60 billion. In addition, two investment pools were set up totaling $52.5 billion to purchase “bad” assets.
Headline – Treasury Announces TARP Capital Purchase Program Description
My Headline – “Let’s See if This Works”
What Happened – This is the direct equity infusion into banks that we have all been hearing about. The Troubled Asset Relief Program (TARP) has been initially funded with $250 billion and it is available to all U.S. controlled banks, savings associations, and certain other bank and savings and loan holding companies engaged only in permitted financial activities. In order to gain access to the capital, there are terms that the companies must adhere too. An interesting response to this measure is that a lot of financial institutions like insurance companies have created Qualified Financial Institutions through which they will be able to participate in the program.
Headline – Treasury Announces Temporary Guarantee Program for Money Market Funds
My Headline – “Got Change for a Dollar?”
What Happened – This is the program that was set up by the treasury to allay people’s’ fears about losing money in the cash equivalent vehicle that we have all come to know and love called the high yielding money market. Money Markets have become main stream cash equivalent of choice, but in reality, they are mutual funds investing in short term debt. Insert sarcasm here, through the due diligence of several of the ratings agency several money market funds were stretching for yield by utilizing Lehman short term debt, one in particular, the “Reserve Fund”, broke a dollar. Breaking a dollar for a Money Market is just one of those things that you just don’t do, because it could cause a stampede of dollars out of all Money Markets. The good thing about Money Market funds is that they carry short term debt, 397 days or less until maturity, and they are widely diversified in their holdings, so events like the ones that we recently experienced usually require a perfect storm of rating agencies not doing their jobs, managers competing for yield not doing their due diligence, and a large issuer of short term debt being used in the funds going bankrupt over night.
Temporary Guarantee Program for Money Market Funds:
The program set up by the treasury seeks to support the net asset value (the “NAV”) of shares held by investors in the funds as of the close of business on September 19, 2008. The program intends to protect those assets against loss if a fund liquidates its holdings and the NAV at the time of liquidation is less than $1 per share. For each shareholder, the program covers the lesser of the following two amounts: (1) the number of shares owned on September 19, 2008, or (2) the number of shares owned on the date the Fund’s NAV falls below $1. Shares acquired after September 19 generally are not eligible for coverage under the program. The program is due to expire on December 18, 2008, unless extended by the Treasury. Each fund will bear the expense of its participation in the program. For the initial three months of the program, each fund will pay 0.01% based on its net assets as of September 19, 2008. The Secretary of the Treasury has authority to extend the program through the close of business on September 18, 2009. If the program is extended beyond December 18, however, there is no assurance that the funds will continue to participate. As of 10/8/2008, the program has approximately $50 billion available to support all participating money market funds.
Update to “Understanding the Letters That Protect Your Money”
UPDATE: FDIC Ups Coverage Limits to $250,000
What Happened – FDIC increased the coverage limits on all accounts up to $250,000 except for IRA accounts which were already at the $250,000 limit. In general, the increased coverage limits will apply through December 31st, 2009. Non-interest Bearing Transaction Accounts were given unlimited coverage for 30 days, but after that banks have to decide if they want to pay in order to maintain their coverage beyond the $250,000 in the special program that the FDIC created as part of the Temporary Liquidity Guarantee Program (TLGP). In addition, the FDIC has provided institutions the option to guarantee promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt through the TLGP.
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 FDIC’s rubber hits the road in our daily lives is their 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 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 which 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.
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 Administration, 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 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.
Update – The coverage limit increases at NCUA have moved in lock step with those of the FDIC.
FDIC (Federal Deposit Insurance Corporation)
When we look at the risks that 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 the 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 their 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 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.
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.
Update – I have received several questions regarding the origin of the custodial rules governing broker dealers: The source of these restrictions comes from the General Rules and Regulations created under the Securities Exchange Act of 1934, specifically the Customer Protection Rule 15c3-3. The SEC is the government agency tasked with the job of interpreting and creating rules and regulations surrounding this act.
About the SEC:http://www.sec.gov/about/whatwedo.shtml
The Customer Protection Rule 15c3-3:http://www.law.uc.edu/CCL/34ActRls/rule15c3-3.html
According to my Bailout Bill Calculator between the TARP and AIG, the Treasury has spent $290 billion of the initial $350 billion made available on October 3rd. In order to use the remainder of the $700 billion bail out beyond the $350 billion, the administration will have to go to Congress. I think it’s safe to say that we can expect all of the $700 billion and more will be appropriated and spent over the next year. While the government continues to use the taxpayer checkbook to extinguish the various fires that are popping up throughout our financial system, and there are many, it is nice to know that there is something besides the “Free” Market protecting us. In order to fix the system, the government has stepped up its efforts to establish a floor, through its willingness to spend money, through programs like FDIC and SIPC, and through other recent programs and legislation. The next item on the government’s agenda should be the coordination of their efforts when it comes to devising and implementing solutions in a more consistent manner. Until we get a more coordinated effort, people and businesses will be waiting on the sideline for what’s next or something better.
***After this article was written, Congress has written new checks (Citigroup) and the Treasury has come up with new plans, so I will attempt to keep up with the major programs as they are rolled out.
FDIC Estimation Calculator
Bankrate.com – In general, this website contains a lot of good articles on the topic, but the links to these three articles should give you additional information to supplement the article and the official insurance websites.
Legible version of these Rules and Regulations can be accessed through the website that was put together by the University of Cincinnati College of Law. Cornell also has a similar website. They are updated periodically.