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September 19, 2008

Another Market Update and Schwab's Safety

The activity in the financial markets and on the regulatory front is absolutely amazing. I've been managing money since 1982 when the Dow was well below 1,000, and I have never seen anything like this, not even the 1987 crash.

My operating thesis this week was that we had reached a turning point in the credit crisis as Wall Street finally accepted its magnitude and important initial steps were taken to stabilize it. The next step in my logic was that Wall Street would turn its attention increasingly toward the impact of the credit market turmoil on US and global economic growth. While my opinion is that the resiliency we have seen in economic growth here and abroad would continue, what is really important is that Wall Street can analyze and efficiently price a recession but it can't analyze and efficiently price a global collapse of credit markets.

An old saying is that Wall Street likes certainty. Before the extraordinary actions taken by the government yesterday and today the level of uncertainty had been reduced. This was the reason I decided to begin to invest client cash reserves during trading on Tuesday and Wednesday. I am only bringing reserves down slightly and still feel above average reserves are prudent especially as stock futures today are presently forecasting another 5% gain.

The actions by the government to guarantee money market funds and begin the process of establishing an entity to takeover bad mortgage loans throughout the system have dramatically reduced systemic risk and should put to rest concerns many have about the safety of their assets at various financial institutions. Nevertheless, I wanted to pass along some information I have received from Schwab regarding the safety of Northlake client assets....

....Schwab has not been implicated in the issues that got Lehman, AIG, Bear Stearns, and others in trouble. Schwab's business model is far different and does not include capital markets activity. Schwab's primary exposure is in its own mortgage lending to its brokerage clients and its money market funds.

Schwab does have one issue with a quasi money market fund which produced large losses for owners. The fund was not large enough that lawsuits would threaten Schwab's financial viability. According to the attached pdf on Schwab money market funds it does not appear that any other funds are in trouble. Of course, the government is now backing money markets so it should not matter if other assets they own are in trouble. As far as their mortgage lending goes, there is no way to know how many bad loans they hold but given that this is not Schwab's primary business it seems unlikely that losses would threaten the company.

Let's postulate, however, that Schwab got in trouble and declared bankruptcy. The other attached pdf on asset safety addresses this issue and should be extremely comforting. The presentation is long and complex. Here are the key points:

• Client assets are not commingled with Schwab corporate assets and Schwab creditors have absolutely no right to them in a bankruptcy.
• Client assets are protected via SIPC insurance and a Lloyd's policy.
• The primary risk to clients is that "assets go missing." This could occur because Schwab lends client assets – no w ay to stop that, it is standard industry practice.
• If client assets are missing, SIPC insurance kicks in and then the Lloyd's policy.
• Losses for any single client are shared pro rata by all Schwab clients. Schwab has $1.4 trillion in assets which means that "losses" would have to be in the hundreds of millions to cause any meaningful loss to an individual client that would not be covered by SIPC or Lloyd's insurance.

The pdf on asset quality contains 25 slides. The most important slides for you to review are 6, 7, 15, and 25. Perhaps the most assurance I can provide is the following quote from the SEC Chairman in April in testimony before Congress about Bear Stearns. This quote appears on slide 7:

"Despite the run on the bank to which Bear Stearns was subjected, its customers were fully protected. At no time…were any of the customers of Bear Stearn's broker-dealer at risk of losing their cash or securities…there is one thing we know to certainty: with or without JPMorgan Chase's acquisition of Bear, and with or without a bankruptcy, Bear Stearn's securities customers are and would have been fully protected from loss of cash or securities."

I guess if the total financial system melts down as appeared to be possible this week, these words may not have proved accurate. However, government actions the last few days seem to have eliminated that risk.

I hope this latest email is helpful. My intention is not to flood your inbox but these are extraordinary times for investors. If you have any questions or comments, please do not hesitate to contact me at anytime including this weekend.

Posted by Steve Birenberg at September 19, 2008 11:19 AM in Stock Market