The Great Writer

Financial institutions face the challenge

Investment banks have the rug pulled out

A crisis of confidence came close to enveloping consumer’s nationwide and only quick action by the Federal Reserve and Congress softened the anxiety.  Despite this, consumers are now viewing financial institutions with a jaundiced eye. 

Record volatility in the stock market and a burgeoning sub-prime debacle rattled many established investment banks and the flight to safety has left investors wondering who will be next and who has the fortitude to survive?  The Chicago Board Options Exchange (CBOE) Volatility Index, a measure of investor anxiety has reached record highs recently.  The five major investment banks have vanished.

The leading financial institutions have taken tens of billions of dollars in credit-related losses.  Citigroup and Merrill Lynch alone account for more than $100 billion in asset ‘writedowns.’

So what does the prudent investor do? Access to mutual fund ratings are everywhere.  Stock ratings and analysis can be found all over the Internet.  But what about the health of brokerage firms?  After all, brokerage firms have exposure to investments tainted by the subprime mess and by extension, their clients do also. How do you ascertain the financial health of a brokerage firm?

Brokerage firms have many competing interests and one of the most important is to practice due diligence.  Their strategists and analysts have to look ahead into the foreseeable future and determine economic trends that might pose risk to the firm and its clients. They then need to create a remediation plan to deal with the risk. As we have seen recently, some firms have been more successful in this effort than others.

SIPC and SEC Minimum capital requirements

Another aspect of a brokerage firm’s health is their standing with the SEC’s minimum capital requirements rule. If a firm maintains only the minimum requirements; this is not always enough to keep it operating smoothly in the face of economic challenges. Brokerage firms must exceed those net capital requirements to provide real protection to their clients.  This is not always a guarantee, since failed Lehman Brothers had nearly five and a half times the minimum requirement.  Consumers are well-advised to check with their own investment firm.  A multiple of the minimum would be desirable.

Brokerage firms have several ways to protect investor’s funds. While they cannot protect against market fluctuations, they can buy additional insurance and maintain excess capital.  

The Securities Investor Protection Corporation (SIPC) provides protection to investors in two ways.  If a brokerage firm fails, investors get back all securities (such as stocks and bonds) registered in their name up to a ceiling of $500,000. SIPC also covers up to a maximum of $100,000 in cash. The exception is when the securities holder is also an officer of the firm.

Another avenue available to investors is a transfer of the account from the failed firm to another brokerage firm that is healthy. A court-appointed trustee overseeing a failed brokerage firm can, with the assistance of SIPC, transfer a client’s account to a healthy firm. Clients then have the option of transferring the account to yet another firm if they wish.

What is the health of major brokers?

Brokerage firms can be ranked using several criteria. They can be ranked based on capital or numbers of brokers or investor assets.  As the chart below illustrates, profits have been harmed by the fallout from mortgage backed securities and derivatives.

1              Source: 6/30/2008 10-Q
2              Source: 6/27/2008 10-Q
3              Source: 8/1/2008   10-Q  (Assets and Shareholder Equity-6/30/08)
4              Source:10/8/2008  10-Q
5              Source:10/9/2008   10-Q
6              Source: 6/30/2008  10-Q
7              Source: 6/30/2008  10-Q
8              Source: 6/30/2008  Foreign firm-web site figures
9              Source: 10/21/2008 10-Q
10            Source:  8/7/2008  10-Q 

A spate of new brokerage firms

The recent shake-up in the financial services market makes ranking a brokerage firm an exercise in futility. Bank of America purchased Merrill Lynch, portions of Lehman Brothers will be bought by a Japanese company, Bear Stearns was acquired by JP Morgan-Chase. And that is just in recent months. Not long ago, it was A.G. Edwards and Prudential Securities that were both making news.

What consumers need to focus on is that most brokerage firms will require a period of rebuilding and restructuring.

For those firms that only require a lifeline, who do not have catastrophic problems, there are healthy firms ready to make an offer and get investors back to business as usual.  The trend has most noticeably been a spate of mergers with banks, creating fewer problems for the clients of brokerage firms than the brokers who work for them.  The client may experience more telemarketing calls as the banking and brokerage businesses try to provide each other with new leads.  But this is a small price to pay for the security of a combined company with more capital.

In the meantime, smaller consumer banks, and those with large portfolios of bad loans will make news. The investment banking sector will be a memory for the most part.  Where consolidations occurred, with Merrill and B of A being the notable one, the structure of the brokerage firm was permanently changed. 

In the final analysis, each institutions exposure to toxic mortgages, and their further exposure to mortgage derivatives, have left investors feeling uneasy.  These securities will pose a drag on the system for some time to come.