When Investment Banks Fail, What Happens to the Little Guy?

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One of the most frightening things (to me) about the 2008 investment bank failures of Lehman Brothers and Bear Stearns coupled with the fraud of Bernie Madoff is the impact it had on individual investors who had used these groups as a means to invest. It’s no different than what most of us do with our 401(k) plans and our Roth IRAs and our other investment plans: we put that money with an investment house, using them to facilitate our investment into stocks or bonds or real estate or money markets or gold or porkbellies or whatever it is we choose to invest in.

I’m no different. I have a Roth IRA through Vanguard, as well as an individual investment account there with which I’m investing with the goal of eventually buying land in the country and building a home. My money is sitting there in those accounts. It’s the product of a lot of hard work and it represents a lot of dreams for the future.

What happens to those dreams, though, if Vanguard were to fail? Lehman Brothers failed. Bear Stearns failed. What happens if your investment house of choice buys into the next bubble for whatever reason, sits there while the bubble collapses, then finds that they can’t cover the withdrawals that people are making?

What happens to your money then?

Enter the SIPC
The SIPC is the Securities Investor Protection Corporation, whose website you can visit at sipc.org. The SIPC’s mission is to step in when a troubled investment house has missing assets – meaning they took the assets held by individual investor(s) like you or me and used them to cover other expenses in a desperate hour, which was then followed by a complete collapse of the investment house or a near-collapse in which people attempted to withdraw assets that were not there.

This might happen, for example, if there’s a “run” on an investment house when there are rumors that they are having trouble (where lots of people simultaneously try to clear out their accounts), or if an investment house does not have the assets available to keep their doors open.

These investment houses purchase insurance from the SIPC on the accounts that they manage as a service to their customers, and you can usually find information about their SIPC affiliation on their website. Vanguard, for example, discusses their SIPC insurance on their brokerage FAQ page.

What the SIPC Is Not
“If that’s the case, why isn’t this just part of the same FDIC insurance that banks offer on savings accounts?” you might be asking yourself.

The key difference is that SIPC insurance does not protect you against investment losses. If the stock market loses 90% of its value next week, SIPC insurance on your account will not help you one whit. Instead, it merely reimburses you for the value of your account at a moment when you would try to withdraw it and the investment house could not comply with your withdrawal.

Most investment types have some risk of investment loss. Your stocks might lose value. Your home might depreciate. Your bonds might not retain as much value as you hope. Porkbellies might become soft. SIPC insurance does not protect you against investment loss.

What SIPC insurance protects you against is investment house fraud and mismanagement, not poor investment choices.

What You Can Do
First, make sure that your investments are in an institution that carries SIPC insurance. Visit their websites and click around a bit to find out, and if you can’t, send them an email asking about it. Virtually all large investment houses are covered by such insurance.

Second, manage your money with respect to SIPC insurance. Keep in mind that if you exceed SIPC insurance limits (often $500,000), your excess would disappear in the event of your institution’s failure. While it’s a tiny risk, it is one worth noting, particularly if you’re considering diversifying your money across multiple investment houses.

Finally, avoid investments that don’t have SIPC insurance. I would generally feel as though an investment firm without SIPC insurance might not have my best interests in mind, and thus I would avoid them.

For most of you, SIPC insurance is mostly an extra dose of security that will help you sleep a little sounder at night.

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6 thoughts on “When Investment Banks Fail, What Happens to the Little Guy?

  1. The obvious solution is to convince the right people to say that you’re too big to fail during the next round of bailouts.

    I think there’s a bigger issue with stock and bond investments. Most of the trading is done by big investment banks and firms using automated electronic trading and with little regulation. If that doesn’t scare you away from the stock market, then nothing will.

  2. “First, make sure that your investments are in an institution that carries SIPC insurance. Visit their websites and click around a bit to find out, and if you can’t, send them an email asking about it. Virtually all large investment houses are covered by such insurance.”

    If I’m suspicious that my investment firm is doing shady things with my money and lying about it, why should I trust them if they claim to carry SIPC insurance?

    Wouldn’t it make more sense to query the SIPC about my investment firm, instead of the other way around?

  3. @Aaron: Don’t assume the deck is stacked against you as a small investor. As a former professional investor, I can say with 100% confidence that the so-called “big guys” can be just as herd-like and just as dumb when it comes to investing as any of the so-called “little guys.”

    Dan @ Casual Kitchen

  4. Dan, there’s a new article on Infoworld.com, “Hackers find new way to cheat on Wall Street — to everyone’s peril:
    ‘Side-channel’ attack on high-frequency trading networks could net a hacker millions of dollars in just seconds — and leave everyone else that much poorer.”

    This is why I have so little faith. This sounds a lot like what Goldman Sachs does with their trading software.

  5. “Second, manage your money with respect to SIPC insurance. Keep in mind that if you exceed SIPC insurance limits (often $500,000), your excess would disappear in the event of your institution’s failure.”

    Not true. Your excess only disappears if the institution fails AND the firm has previously stolen or lost your assets. Investment firms are not allowed to commingle your assets with theirs, so unless there is fraud or gross mismanagement where they simply lose your securities, your investments are safe. Even if the investment firm fails, your assets (including assets over $500,000) are kept distinct from the firms assets and therefore are recoverable. Only in frauds – like Madoffs – does the SIPC come in. In the case of Lehman – a bankruptcy in absence of fraud – all customer accounts were fine. No SIPC insurance payout was required.

    “Finally, avoid investments that don’t have SIPC insurance.”

    Investments don’t have SIPC insurance, investment firms do. You cannot find investments with SIPC insurance, only investment firms.

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