Monday, December 12, 2011

Is Your Money Safe at Merrill Lynch and Fidelity?

The MF Global debacle has clearly shaken people up. Despite devoting one major post to the safety of investment accounts, I continue to receive email questions about the safety of specific firms including Merrill Lynch and Fidelity.

As a follow up to my initial post, here are a few thoughts.

Is your money safe at Merrill Lynch and Fidelity? Most likely, yes.

BUT, I would have said the same thing about the commodity brokerage firm Lind-Walldack, which was owned by MF Global and where client accounts are now frozen.

The blow up of MF Global is not an unusual event. Many hedge funds have blown up in recent years (e.g. Long Term Capital Managemnet), and brokerage firms have blown up (e.g. Lehman Brothers), but it is rare for supposedly segregated funds do be involved in such blow ups.

In the case of hedge funds, they usually don't own brokerage firms. In the case, of brokerage firms, they usually don't dip into segregated funds because that is a major violation (read: jail time). You need someone pretty desperate and not thinking very clearly do so.

Francine McKenna reports at Forbes:
The CME conducted an audit of segregated funds on October 24. According to several published accounts, this review was completed that same day. At that time, the CME says, “MF Global was in compliance with its segregation requirements.”...On October 27, Thursday, as a result of the earnings call, Moody’s reduced MF Global two more steps to Ba2 and put it under review for more possible cuts. Bloomberg reported that the company had exhausted all of its credit lines the night before.
This is most likely when the real desperation kicked in. Bankruptcy should have been filed right then, but instead, a decision was likely made to use client segregated assets to meet margin calls, insanely hoping that markets would turnaround in a day or two and the assets would be put back in client accounts without any clients aware of the major violation that had occurred, or perhaps hope it would buy time to sell the firm.

McKenna describes a very strong plausible theory on how the thinking would have gone down, if Corzine was hoping to sell the firm:
I’ve given those who executed the “nuclear option” to save MF Global the benefit of the doubt. I believe those executives used all available legitimate means to raise cash first, including trying to sell proprietary assets, as CNBC reported, and exhausting existing credit lines. When margin calls on the repurchase agreements and account closure demands from strategically important clients – not the bread and butter individual traders and smaller investors and money managers who got rubber checks – kept coming, they hit the wall.

Why do I believe MF Global executives transferred customer assets not cash to “house” accounts? Because missing cash would be noticed immediately. Their clients were still trading and clearing and cash was required to settle. Securities such as U.S. Treasury Bills, blue-chip equities such as CME Group stock held by many exchange members, and physical assets such as gold, warehouse receipts, and other certificates of title are less active. They would not be missed Thursday through Monday.

What did MF Global do once these assets were moved to a “house” account? I believe they pledged the customer assets as collateral for a short term loan...Corzine planned to sell the company not file bankruptcy.

There was no time to monetize the assets by selling them outright. That would have made replacing them quickly, in kind, much more difficult. A privately arranged line of credit, secured by a basket of assets discounted by up to 50% due to the risk of default and the firm’s desperation, could be unwound as soon as a deal to sell the firm was struck. All the assets could go back into the customer accounts and no one would be the wiser.

Any firm willing to lend $300-400 million for a week or so against approximately $700 million of customer assets was certainly wise enough to require recourse to those assets in the event of a bankruptcy. Some of the assets, like CME stock, were sure to drop in value if the bankruptcy occurred.

When MF Global filed for bankruptcy midday on Monday October 31, 2011, the lender owned the customer assets.

My guess is the pledged assets were immediately liquidated.
In other words, this was a situation that developed over a very short-term period that an outside accounting firm would have little chance of catching.

Could this type of thing happen at Fidelity or Merrill Lynch?  Very unlikely. Fidelity is an entirely different operation with no leveraged hedge fund activities that I am aware of. Merrill Lynch is owned by Bank of America, a bank that seemingly is considered TBTF by the government, This probably also means Merrill.

That said, we live in very unusual economic times. It's hard to see how Fidelity or Merrill would get themselves into such a desperate financial situation with desperate man at the top making very desperate decisions , but it can't be ruled out. The best thing, as I pointed out in my first post on this topic, is to diversify your assets over many different firms, and where possible take delivery of certificates, gold and cash.


  1. Won't speak for Merrill, but as far as Fidelity goes, this is from their website:

    What's missing in this analysis too, is that Fidelity's Mutual Funds each, separately, are individual companies unto themselves. FMR Corp- a fidelity subsidiary- serves as the investment advisor to all of the funds. Therefore, when you see that "Fidelity" is the largest shareholder of a given company, that is actually FMR Corp, and it is on behalf of hundreds of Fidelity Funds. So when something like this happens, you'll see Fidelity's name but the stock in question usually represents a very tiny percentage of a number of different funds and therefore the effect is negligible on Fidelity as a whole (and the funds that hold the stock, too, since it is merely a small holding). Fidelity is so big, they are one of the top 10 holders of a ton of different stocks... but again, it's across hundreds of mutual funds so it's deceiving to think they are at risk from the failure of one company; or, even in the extremely unlikely event of the failure of one fund.

    Diversifying across various firms serves little purpose, in most cases, if it's merely regarding protection of assets. Check the insurance protection that your brokerage firm partakes in. Most of them have the same type of SIPC coverage (usually $500k, only 100 of which can be cash); then check the excess coverage they have on top of that.

    The SEC Customer Protection Rule further stipulates that client assets be segregated from firm assets so that even in the unlikely event of firm failure, client assets are untouched and can simply be moved to a new firm. It is only in the case of fraud, etc, when client assets are lost (like in the MF Global case) where SIPC protection would cover eligible assets anyways (again, check your firm's participation and coverage levels, etc).

    So "diversifying" across multiple firms is largely a myth that serves no real purpose for the vast majority of investors, particularly as it pertains to Fidelity. Most will lose their money through stupid investing on their own before they'll ever have to worry about their firm going belly up and losing their assets.

  2. Merrill trades for its own account. Fidelity merely serves as a brokerage. The closest that Fidelity comes to investing for its own account is its venture capital arm.

    I would not trust having money at Merrill. It is apt to go broke from leveraged trades gone bad. Fidelity (and Vanguard) does not have that risk.

    Sure, BoA/Merrill is too big to fail. It is also too big to save, seems to me, as its failure will probably be accompanied by MS, Citi, JPM, and GS being in dire straits, too.

  3. MFG did not need to co-mingle customer funds. As I understand it they were allowed within the rules to repo sovereign debt for customer accounts and keep the profits for themselves.