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That’s the question a client asked me last week, after he watched Jon Corzine, former CEO of MF Global, testify to a Congressional committee about the $1.2 billion missing from MF Global client brokerage accounts. He wanted to know if his investment account at Fidelity was at risk.

The MF Global collapse is similar to that of Lehman Brothers and Bear Stearns that occurred during 2008, when brokerage companies traded to make profits for themselves and made poor decisions that led to their undoing. During the same time we watched Bernie Madoff’s long- term Ponzi scheme unravel, and read about other investor losses here in Greater Cincinnati. Taken together, it’s no wonder he’s worried. In my next blog, I’ll discuss the common elements of investor scams that have occurred nationally and locally. Today I’ll address brokerage account risk, and compare MF Global to Fidelity Institutional Wealth Services and the Charles Schwab Corporation, the two brokerage firms we use to custody our client accounts. There are four major differences in MF Global operations and those of Fidelity and Schwab:

Company Focus
MF Global’s core business was providing brokerage execution and clearing services for derivatives traded on global exchanges and over-the-counter markets, and many of their clients were hedge funds and institutional money managers. It was in the process of trying to diversify into other areas, but was not as diversified as Fidelity or Schwab. Both Fidelity and Schwab provide retail and institutional brokerage services for a broad variety of clients as well as mutual fund management. This diversification of revenue sources helps to make them stronger.

Financial Strength and Regulation
The Standard & Poor’s ratings analysis on MF Global published on December 13, 2010 assigned the company a –BBB rating (the 10th S&P rating level, almost ‘junk’ ). S&P pointed out that the company had suffered losses for the year 2010 and for every year going back to 2008. For the first six months of fiscal 2011 they reported a net loss of $29.9 million. At the time, the company held only $253 million in excess capital over the regulatory minimum. Fidelity and Schwab have much stronger financial profiles. Fidelity had equity of $2.4 billion as of June 30, 2011 and carried a rating of A+ (the 5th level) from S&P, while Schwab held $6.7 billion in equity capital and an A rating (6th level) for the same period.

Even though MF Global was also a registered broker-dealer, the company primarily held commodity accounts, not securities accounts, which are supervised by the Commodity Futures Trading Commission. The Securities Investor Protection Corporation (SIPC) offers $500,000 protection on securities accounts, like those held at Fidelity and Schwab, but there is no equivalent insurance for commodities accounts. In addition, both Schwab and Fidelity have private insurance coverage in excess of the SIPC limit.

Client Agreements
Commodity brokerage firms are permitted to use cash in client accounts for their own trading, subject to certain restrictions. In fact, MF Global’s standard client agreement permitted the firm to “borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan or invest any of the collateral” in customer accounts. This practice has been an additional source of revenue for the commodities industry for decades, but companies are supposed to segregate client money from company funds. In the final days of MF Global, when Mr. Corzine was scrambling to cover proprietary trades he had made on behalf of the company, his accounting apparently got sloppy.

Schwab and Fidelity client agreements do not permit them to borrow funds from client accounts.

Regulatory History and Character
According to the S&P financial report I referred to earlier, MF Global had more regulatory actions than other rated brokerage companies. In addition, in 2008 the company suffered an “unusual” loss due to unauthorized trading inside the company. They didn’t exactly have a stellar track record. Both Fidelity and Schwab have respected regulatory records.

John Corzine held the office of both Chairman and CEO at the company, and had lots of concentrated power with little oversight. He was CEO of Goldman Sachs in 1999 before he was pushed out, but had been out of the financial industry for 12 years while he worked in politics. He was anxious to make a name for himself and took increasing risks with the company’s proprietary trading to increase profits at the firm. As I wrote in my November 8th blog, that did not work out well.

It’s important to know the companies you do business with, and the people who stand behind them. No matter how sophisticated the world gets, it’s the strength of character of the people you work with that still matters most.

Jeannette A. Jones, CPA, CFP®