Bonding could protect investors

by Stephen Butler

The Bernie Madoff fiasco prompts me to wonder if the ubiquitous "Member of the Security Investors Protection Corporation" (SIPC) means very much right now for those of us who were never given the chance to invest with Bernie.

Could it be that the $164 million paid out to Madoff victims thus far is just the beginning of the tsunami that will wipe out SIPC's coffers? How on earth will the brokerage industry's self-styled umbrella of protection round up enough money to replace tens of billions in stolen assets?

Why does SIPC even need to exist? Why wouldn't just routine bonding insurance protect against theft? Answer: Because when you allow your stocks to be owned "in street name" at your brokerage firm instead of having certificates actually delivered to you for safe keeping, the brokerage firm can borrow for its own account using those assets as collateral. That's not theft. It's just risk that bonding can't cover.

Brokerage companies can borrow as much as 15 times the value of your shares. Read the fine print of the contract you actually signed when you set up your account. On the firms' own money - actual profits that they have made over the years and that remain as retained earnings - the brokerage industry (since 2004) has been allowed to borrow as much as 30 times their net worth.

Like a needle in the arm, we now know that with the narcotic of this much leverage, brokerage firms like Merrill Lynch and Lehman Brothers can go right down the tubes, and our money can go with them.

What may have been only an academic interest in the small-print reference to SIPC membership at the bottom of our brokers' correspondence suddenly takes on new meaning.

SIPC protects basically small investors up to a maximum of $500,000. It has been rare for any brokerage firm to go out of business. If your money is in mutual funds, you can relax because the fund companies know what they're doing. They write their own agreements with the brokerage industry that protect fund assets from possible exposure.

To illustrate how extensive and creative are the mysteries behind the veil of the brokerage industry, I recall reading not long ago that an estimated 25 percent of Charles Schwab profits were derived from interest earned on loans of customer securities for short sale purposes. This is probably true industrywide.

The next few months will determine whether or not our SIPC protection is worth anything. It's to their credit that SIPC has paid out as much as they have so far.

It may be reassuring to know that we have at least $500,000 worth of safety net, but the question to ask is why we tolerate a system that requires it at all. We must be slow learners. During the Reagan-era deregulation of savings and loans, greed-fueled institutions failed when wild bets on real estate went bad. Fortune magazine ran an article at the time that pictured about 350 S&L executives that had been sent to jail - a two-page spread of tiny portraits that resembled those insurance ads picturing the year's leading salesmen. Jail sentences may be satisfying at some level, but they are too little too late.

In the end, we're alone with our money. Read the fine print and avoid anything that looks too good to be true.

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