What if brokage firms go bankrupt?

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The drama in wall street did not end on last Friday. Today E-Trade, the few dot com survivor, came into news about is exposure to Mortgage Backed Securities (MBS). In these days, MBS are pretty much like useless paper, because of the sub-prime crisis. Accoring to analyst, the chance of E-Trade go bankrupt is still remote, or 15%. But this will make the E-Trade investors and customers nervous, and its competitors happy. So, what if E-Trader eventually do go bankrupt? What does that mean to its investors and customers?

For E-Trader investors (stock holders of ETFC), it is simple: that means total loss.

e-trade logo

For its customers, it’s more complicated. From my observations in the bankrupcy of Chinese brokage firms (before current bull market), the brokage firms may well use their clients shares as a collateral to trade on options, or to get a new loan, or do other risky things etc. I am not saying E-Trade is doing the same thing, but from their investment in MBS, we can not rule it out. Luckily for E-Trade customers, unlike buying shares from Chinese brokage firms an investor is on his/her own, buying shares from E-Trade carries SIPC insurance in the case of broker default. SIPC is similar to FDIC for the bank deposit in the case of bank go under. I just realized E-trade does have bank accounts, so FDIC rule (100,000 limit) does apply to its banking customers.

Regarding SIPC, here is what I read from trader818: E*TRADE Securities LLC and E*TRADE Clearing LLC are members of SIPC, which protects securities customers of its members up to $500,000 (including $100,000 for claims for cash). Explanatory brochure available upon request or at www.sipc.org. So if a person has more than half a million in E-Trade stock account, he/she should be nervous.

In that case I can think of two things a customer can do to to protect him/herself, if the bankrupcy of a broker is coming: sell the shares (take the money); or transfer the shares. Each approach has its pros and cons. Sell the shares means take the loss (or smaller profit) in current market, plus the commissions. While transfer shares to another broker temparorily saves the commissons to sell the shares, there maybe a transfer fee imposed both by E-Trade and the new broker; more importantly, the transfer itself could take time, with current market condition, it could mean a bigger portfolio loss when one eventually decide to sell.

How about stay put? It maybe well be the best approach. Because E-Trade is unlikely to eventually go bankrupcy, and when the market warms up again, the investor could decide whether to keep or sell. And in the worst case scenario, one can get insurance reimbursement.

Warning: this is mostly a theortical discussion of what happens when brokers go bankrupt. If you follow my advice and later regret about it, you are on your own and I will not be responsible for that.

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