Will Safety Nets Protect Retail Brokerage Assets?

That's what investors shell-shocked by the dizzying collapse of Bear Stearns (BSC) have been asking me this week. After all, Bear Stearns was a firm that seemed to have a healthy balance sheet just a week ago, and is now being sold for a mere $2 a share. Without a Fed-engineered takeover by J.P. Morgan Chase (JPM), it would be bankrupt.

Bear Stearns didn't have a retail brokerage operation and didn't cater to individual investors. But if this catastrophe could strike there, why not at other firms that do have big retail operations, like Merrill Lynch (MER), Citigroup (C)-owned Smith Barney, Morgan Stanley (MS), or even Goldman Sachs (GS), which has plenty of high-net-worth clients? If any of these firms failed, what would happen to their client accounts?

It's a sign of the times that such a dire subject even needs to be addressed. I can understand people's concerns, especially in the wake of the auction rate preferred crisis, when clients of these firms woke up to discover that what was sold to them as liquid money-market accounts were frozen (and for the most part remain so). Now people are worrying about even basic money-market funds.

Before anyone panics and starts another run on a big bank, let me say unequivocally that client assets in the big brokerage firms are safe from the danger of any Bear Stearns-type collapse. Client accounts are subject to multiple safety nets. And by offering what is essentially unlimited liquidity to the nation's primary dealers (which include Merrill, Citigroup, Morgan Stanley and Goldman), the Federal Reserve just added another important one.

All the big brokerage firms assert that their healthy balance sheets are the first line of defense for their clients. They do seem healthy, even after the hits taken from exposure to mortgage-backed securities. Goldman Sachs and Lehman Brothers (LEH) both reported better-than-expected earnings this week, assuaging some fears. But, then again, Bear Stearns was contending that it had a healthy balance sheet just last week. Bear Stearns looked like it had a book value of about $84 a share — and then said an offer of $2 was the best that could be hoped for. This is what has so shaken many investors and caused them to worry. So let's assume the worst.

In such scenarios, the Federal Reserve and its new accommodative lending policy would kick in. The Fed is apparently willing to take just about anything as collateral, even the now-illiquid securities that caused so much trouble for Bear Stearns. That means creditors who demand their money back can get paid, or if you want to withdraw or transfer your assets, you can. Given the Fed's willingness to lend, another Bear Stearns seems highly unlikely, which is why I'm puzzled by the worries about Lehman Brothers. Lehman's business may suffer, but it shouldn't be forced into insolvency. It has a generous capital cushion and direct access to the Fed.

Moreover, by pushing Bear Stearns into a merger, the Fed made sure it continues as a going concern. J.P. Morgan Chase said it will honor all of Bear Stearns's commitments to customers. This would be even more important to prevent disruption to the financial system and economy if the firm were a big retail broker.

Even if the Fed couldn't prevent panic withdrawals, brokerage assets are protected. The Securities and Exchange Commission, under the so-called "net capital rule," requires all U.S. brokerage firms to maintain readily marketable assets sufficient to repay all current obligations to customers. So even if a firm had to be liquidated, client accounts would be repaid.

As an additional safeguard, customer assets are segregated from a firm's assets and aren't carried on the balance sheet. Holding securities with a brokerage firm is as safe as with a bank or trust company and they are protected against creditors' claims.

In addition, should a firm fail, the Securities Investor Protection Corporation (SIPC) covers any client losses in securities up to $500,000. Most, if not all, firms also have insurance that protects clients from any losses that exceed $500,000. And cash held in bank accounts is protected by the Federal Deposit Insurance Corporation up to $100,000.

Of course, none of this protects an investor from losses due to declining asset prices, which is market risk. But the potential failure of a large firm is no reason for individual investors to worry about the safety of their assets. However flawed at times, the U.S. has the best securities regulatory system in the world, and at times like this, I'm glad it does.