Money doesn't actually talk. We do.

The Safety Nets for E-Trade Account Holders

Nothing’s happened to online broker E*Trade. Well, not anything that affects people who keep their money there.

But its stock lost more than half its value yesterday, and rumblings of bigger trouble started coming across the wire (cue sharks, vultures who are eager to steal nervous E*Trade customers; we started hearing from at least one of their public relations representatives yesterday).

All this occurred after a Wall Street analyst said E*Trade could go bankrupt if people withdraw their money from the firm in the shadow of the continuing subprime mortgage crisis. Turns out E*Trade has a lot of money in the subprime business and is likely to take a financial hit, and soon (how big a hit is still in question).

The E*Trade anxiety raises an interesting hypothetical: What happens to investors when their brokerage fails?

When banks fail, customers get up to $100,000 in FDIC insurance, no questions asked. But investors are not bank customers–risk is part of the game.

What would likely happen to most customers of a failed brokerage is that their accounts would be assumed by a competitor (not unlike how NetBank customers woke up a few weeks ago to discover they were now ING customers). It’s a relatively seamless transition, and it would happen very quickly.

But there is another level of protection: SIPC (Securities Investor Protection Corporation) insurance. The SIPC does not come to the rescue if your stocks tank, or if you trade like an idiot. Perhaps better to let them describe:

SIPC does not bail out investors when the value of their stocks, bonds and other investments falls for any reason. Instead, SIPC replaces missing stocks and other securities where it is possible to do so…even when investments have increased in value.

When do investments go “missing?” Well, when a brokerage closes shop is one possibility (not that we think this is where E*Trade is headed). Outright theft or fraud is another–although being sold worthless stocks is not covered (you should’ve known better, goes the logic). The general maximum for SIPC coverage is $500,000 per investor (up to $100,000 of which can be cash), though more money may be available after the brokerage has been liquidated.

In addition to that, each brokerage may take out additional insurance to cover investors. E*Trade, for example, has a $600 million policy that will pay out a maximum of $150 million to an individual investor (with a maximum of $900,000 paid back in cash), should customers need to collect on it.

Here’s hoping they don’t have to use it.
– Sam Grobart